President Trump and Senate Majority Leader Mitch McConnell (R-Ky.) are courting an economic catastrophe with a standoff over how to raise the debt limit.
Unless Trump and Congress pass a law raising the U.S. debt limit — a legal cap on how much the U.S. government is allowed to borrow — the Treasury Department will soon run out of money to pay its bills, triggering a first-in-modern-U.S.-history default that threatens to turn the world economy on its head. A default would crack the world’s faith in the United States’ ability to pay its bills and repay its loans, and that faith serves as the underpinning of the entire global financial system.
“Failure to raise the debt ceiling would ... likely push the economy into a recession if the situation persisted,” Barclays warned in a note to clients on Thursday.
The overriding belief in Washington and on Wall Street is that a default is highly unlikely. But there's still a chance it could happen. Greg Valliere of Horizon Investments puts the odds at 5 percent. Given what's at stake, that's not comforting.
The most recent estimates suggest Congress has until early October to take action before the government literally runs out of money. It’s called the “X” date, and it could occur as early as Oct. 2, according to the Bipartisan Policy Center. A large ($81 billion) payment is due to the Military Retirement Trust Fund that day. If there aren't enough tax dollars left in the Treasury to make that payment and the others due that day, the Trump administration will have to pick who goes empty-handed.
With time running short, Trump is bashing McConnell, and the two leaders are involved in a prickly feud.
While both leaders are blaming the other, each has his own complicated history with the debt ceiling that helped bring us here. Trump’s administration has sent a divided message on how to proceed. Treasury Secretary Steven Mnuchin has been telling Congress to pass a simple increase as soon as possible that isn’t linked to anything else, while Mick Mulvaney, Trump’s budget director, has been hinting to conservatives that they could push for spending cuts by threatening to withhold their votes for a debt ceiling increase.
McConnell has his own complicated history with the debt ceiling, as he was part of a Republican effort in 2013 to withhold a debt ceiling increase from President Barack Obama unless the president agreed to spending cuts, the same tactic that his fellow conservatives are threatening to use now. What’s different this time is that Republicans are fighting each other, not a Democrat.
The danger of this ongoing game of chicken, however, is that at some point someone will miscalculate and the government will actually hit the debt limit, sparking a default, intentional or otherwise.
Here are five reasons that would cause global panic.
First, it would trigger a wild ride for stocks and bonds. Wall Street doesn’t like bad surprises. This would be a big one. It would be “unprecedented in the modern era,” says Shai Akabas, economic policy director at the Bipartisan Policy Center. There would probably be an immediate, negative reaction in the markets, especially for U.S. stocks and bonds. It's hard to predict how ugly it would get, but investors would be digesting both the shock that the “full faith and credit of the United States” is tarnished and the fact that Trump and Congress probably won't get tax reform done if they can't even accomplish a “must do” item.
Second, America's cheap funding source would end. The United States can borrow money at extremely low rates because there's a fundamental belief around the world that America always pays its debts on time. That's why America still has a top-notch AAA credit rating (at least from two of three main rating agencies). As soon as the United States actually defaults, investors would start suing the country, and they would almost certainly insist on much higher interest rates in the future.
It's already happening. The fear of a potential default in October has sent America's short-term bond yields (known as T-bills) much higher than usual. A similar spike happened in 2011 and 2013 when America also got close to its “X” date. It cost the United States hundreds of millions more in interest, according to a Federal Reserve study. If an actual default happens, taxpayers would end up with an even bigger bill (think billions more dollars, if not worse).
Third, real people won't get paid. This is not a game. The Trump administration would have to either stop payments to everyone or they would have to pick who gets paid and who does not. That means deciding between bondholders, Social Security recipients, welfare recipients, companies that provide equipment to our military, people and businesses awaiting IRS tax refunds, etc. Someone won't get their money. That could easily be a retiree in the United States or overseas, since about half of America's debt is held by foreigners.
Fourth, America’s global power would decline. A default would be a major hit to America's “soft power.” The U.S. dollar is the world's reserve currency. People carry dollars and hold U.S. bonds all over the world because they believe America is their best and safest bet. A default would probably cause the value of the dollar to drop and global investors to shift some money out of U.S. assets. Even a short default could have long-lasting damage to America's reputation. Other countries won't be so quick to “buy American” down the road. And you can bet China, America's largest foreign creditor, will be livid.
Fifth, a recession is possible. Yes, this is a dire scenario. It won't happen on Oct. 2. But hitting the debt limit could cause a sharp drop in markets and sentiment around the world as everyone worries that if the United States defaults, who's next? Investors might start panicking and ditching bonds of other countries in Europe and Asia, too. As we learned in the 2008 financial crisis, once fear takes hold, it's hard to stop the downward spiral.
As Barclays explains, “Failure to raise the debt ceiling would require an immediate cut in spending equal to about 3.5% of GDP. A contraction of federal spending of this magnitude, the risk of default, sovereign reputational risk, and negative consequences for confidence and private sector behavior would likely push the economy into a recession if the situation persisted.”
Everyone from Mnuchin to House Speaker Paul D. Ryan (R-Wis.) says don’t worry, the debt limit will be raised in September, well before the “X” date. But it’s clearly a possibility. That’s why some bond yields are already rising.
“The markets have already started to flash warning signs. In July, three-month Treasury bill rates rose higher than six-month bill rates for only the third time in the last decade,” says Akabas. “This is a clear signal that investors are worried policymakers will not raise the debt limit in time.”
Call it a 5 percent possibility. The question is: Why is the U.S. government even allowing a 5 percent risk of a major catastrophe over something that could so easily be prevented?