How much would debt default damage US? History offers clues.
In negotiating a last-minute deal before the United States runs out of money to pay all its bills, the White House and Republicans in Congress are playing with fire of uncertain heat.
The Treasury says that, perhaps as early as June 1, it can no longer assure that all federal bills will be paid, unless Congress raises the nation’s debt limit to allow resumed borrowing.
Why We Wrote This
Debt limit talks in Washington carry high stakes for the economy. Even going to the brink of default can harm investor confidence. Yet past cases of mini default are reminders that financial armageddon isn’t guaranteed.
Republicans, who control the House of Representatives, are threatening to oppose a debt limit increase if Democrats don’t agree to spending cuts.
The U.S. has at times reneged on promises, such as breaking the dollar off the gold standard in the Great Depression.
Still, history – and each passing day now – shows that even approaching a default on debts can take a toll on financial market confidence. “We have already seen Treasury’s borrowing costs increase substantially for securities maturing in early June,” Secretary Janet Yellen wrote in a letter Monday to House Speaker Kevin McCarthy.
In the mini default of 1979, when technical glitches forced the Treasury to delay payments to bondholders for a few weeks, interest rates on U.S. debt rose 0.6 percentage points and didn’t go back down once the problem was fixed.
In negotiating a last-minute deal before the United States runs out of money to pay all its bills, the White House and Republicans in Congress are playing with fire of uncertain heat.
Every day without a deal takes a toll on financial market confidence, as a possible debt default draws near. The Treasury says that, perhaps as early as June 1, it can no longer assure that all federal bills will be paid, unless Congress raises the nation’s debt limit to allow resumed borrowing.
In one scenario, the politicians reach agreement in time and the damage to America’s reputation remains minimal. In another scenario, talks fail and investors worldwide unload U.S. Treasury bills and notes in a fire sale as the government fails to make all its obligated payments. Stock markets plunge, interest rates surge, and the chaos triggers an international recession.
Why We Wrote This
Debt limit talks in Washington carry high stakes for the economy. Even going to the brink of default can harm investor confidence. Yet past cases of mini default are reminders that financial armageddon isn’t guaranteed.
There is a third scenario, where talks fail but investors don’t panic, at least at first, and market declines goad politicians to reach a deal before causing an economic armageddon.
Uncertainty remains so high because the U.S. has never before gone over the brink in quite this way. But previous episodes when the nation has reneged on its financial commitments suggest that all these scenarios are plausible. If President Joe Biden and Republicans fail to reach a deal before the U.S. Treasury runs out of cash, economic armageddon is not a foregone conclusion.
“I used to think there would be a big disaster right at the moment we missed payments,” says Philip Wallach, an economist at the American Enterprise Institute in Washington “I have to admit that I don’t really think that that is clear anymore.”
That doesn’t mean playing with fire is cost-free in any scenario. In 2011, for example, just going near the debt limit brink cost the government a credit-rating cut (by Standard & Poor’s) that has lasted ever since.
Previous battles over the debt limit have always ended in a last-minute agreement. In this case, the Biden administration and Congress know they ultimately need to raise the debt ceiling to pay for programs already approved by Congress. Republicans, who control the House of Representatives, are threatening to oppose a debt limit increase if Democrats don’t agree to spending cuts. If Treasury can’t issue more debt, it will run out of enough cash to pay its obligations, perhaps as early as June 1.
That scenario would create deep uncertainty, because no one knows how domestic and foreign investors who hold U.S. debt would react. Other big unknowns include how Treasury Secretary Janet Yellen and politicians would respond.
Options for the Treasury
The Treasury, for example, could avoid outright default on its debt by prioritizing payments to bondholders. It’s not clear whether this is legal – and such a move would almost certainly set off a blizzard of lawsuits. But at least there is legal precedent for the courts to step in.
In the depths of the Great Depression, after the U.S. decided to redeem federal gold bonds in currency instead of gold coin, the case went all the way to the U.S. Supreme Court. The court upheld the federal government’s right to go back on its longstanding promise to pay bondholders in gold.
The U.S. has repudiated its financial obligations at other times too, says Alex J. Pollock, a senior fellow at the Mises Institute and author of “Finance and Philosophy – Why We’re Always Surprised.” In 1968, it refused to redeem silver certificate paper dollars for actual silver dollars, despite a written guarantee. Three years later, the U.S. went off the gold standard completely, despite its commitment in an international agreement to convert dollars to gold. The agreement, known as the Bretton Woods system, collapsed.
Even if prioritizing payments were deemed legal, the political challenges could prove equally daunting. Opponents of a potential deal on the debt limit could point out that the Treasury, in effect, would be guaranteeing continued payments to wealthy bondholders, including foreign investors in Japan and China, while simultaneously delaying or cutting payments to Americans including perhaps the most vulnerable. If the Treasury prioritized bondholders and Social Security recipients, it would have to cut payments to other large blocs of voters, such as veterans, federal government employees, welfare recipients, taxpayers due refunds, and so on.
By one estimate, payments to those groups would have to be cut by a third.
If politicians do come up with a deal on raising the debt limit before June 1, they probably won’t escape negative consequences, if history is any guide. When the U.S. saw similar political brinkmanship in 2011 and again in 2013, the interest rates that the Treasury had to pay to borrow rose between 0.04 and 0.46 percentage points, according to Wendy Edelberg, an economist at the Brookings Institution in Washington. In the mini-default of 1979, when technical glitches forced Treasury to delay payments to bondholders for a few weeks, interest rates on U.S. debt rose 0.6 percentage points and didn’t go back down once the problem was fixed. That triggered a $12 billion annual increase in federal interest payments, according to one study.
Bondholders are already reacting this time. “We have already seen Treasury’s borrowing costs increase substantially for securities maturing in early June,” Secretary Yellen wrote in a letter Monday to House Speaker Kevin McCarthy.
Self-imposed turmoil – for a reason?
This financial damage is self-inflicted and unnecessary, economists point out. The need for more borrowing is inherent in spending decisions already approved by Congress. “The only effective solution is for Congress to increase the debt ceiling without delay or, better yet, abolish it,” Ms. Edelberg told Congress in testimony last week.
But the ordinary budget process is so broken that debt limit debates remain one of the few ways that the minority party can call attention to spending and the debt. Republicans hope to use the current talks as leverage to restrain future spending. Both parties have used debt-limit debates to pressure the White House.
“They do serve a purpose,” says Richard Marcus, a finance professor at the University of Wisconsin–Milwaukee and co-author of the study on the 1979 mini default. “They concentrate the mind that we’re spending more than we’re taking in.”
Several solutions have been proposed for an unresolved impasse. Some scholars have suggested President Biden could invoke the 14th Amendment, which says the validity of the nation’s public debt “shall not be questioned,” to ignore the debt ceiling and instruct the Treasury to meet all its obligations. But that would involve a legal tangle over constitutional law and the president himself has said he doesn’t have the necessary time to use the amendment to solve the immediate crisis.
“Hard choices ... is what we need”
Another idea is that the Treasury mint a trillion-dollar platinum coin, sell it to the Federal Reserve, and use the funds to continue paying its bills – a solution Secretary Yellen has called a gimmick. A third idea is to revalue the nation’s gold supply at something closer to its real value and issue gold certificates.
“Eight thousand tonnes of gold is not a gimmick,” says Mr. Pollock of the Mises Institute. “Eight thousand tonnes of gold is reality.”
The last time Congress valued the federal government’s gold was 1973, when it set the price at $42.22 an ounce. By revaluing it at close to today’s market value – gold was trading above $1,950 an ounce on Wednesday – the Treasury could raise some $500 billion, giving Republicans and the president breathing room to hammer out a new budget. That’s what the Eisenhower administration did in 1953, increasing its gold certificates because the price of gold had risen, to overcome a political impasse over the debt ceiling, which Congress eventually raised in 1954.
Of course, that’s just a temporary fix for the underlying problem – a lack of political will to strike the tough compromises that would create viable and sustainable budgets.
“We just need a lot of seriousness applied to the issue, and we don’t have a lot of it today,” says Mr. Wallach at the American Enterprise Institute. “We have a lot of recriminations, a lot of finger pointing, a lot of bad feelings, but not a lot of serious willingness to buckle down and collectively shoulder some hard choices, which is what we need.”
