Eyes are on Capitol Hill as negotiations continue between the White House and Republicans to resolve the debt ceiling standoff. If no spending agreement is reached, the United States could default on its outstanding loans as early as June 1. If that were to happen, then what?
Penn Today asked Harold L. Cole to give a general overview of what happens after the deadline passes. Cole is the James Joo-Jin Kim Professor of Economics in the School of Arts & Sciences, and he’s also a consultant for the Federal Reserve Bank of Philadelphia.
Cole has researched debt crises in developing countries and in the European Union.
“However, this is really different, because the overall impact of what happens in the U.S. is so much bigger and the U.S. debt and currency so underpins the world economy,” Cole says.
Here are three things to know about the looming crisis.
Missing any payments could cause market chaos
“The United States has a huge outstanding debt that is held by the public, which equaled about 94% of the country’s gross domestic product in the fourth quarter of 2022.
This debt is in a variety of maturities so only a portion is coming due soon. However, the longer-term debt also has coupon payments.
I have seen estimates that there is $1 trillion maturing in the month of June, along with $13.6 billion in interest payments.
The U.S. government pays its debts through the Fedwire Funds Service which is a credit transfer service that flows from the Fed into the Fed banks and then into account holders.
Defaulting on some of these payments would probably not mean that the U.S. was in default on all of them. Hence, later-maturing payments will become more attractive, making for a wild reshuffling of assets and potential market chaos.”
Defaulting on payments could lead to downgrades by ratings agencies
“Each time the U.S. misses a payment there is probably going to be a downgrade by the credit rating agencies on at least some of the outstanding debt for at least the first few missed payments. Remember that a credit rating is a forecast of the probability of a default, also called a missed payment. So, clearly, for debt coming due after a series of missed payments, this probably would be going up rapidly, hence we could end up downgraded pretty severely.
There are a number of ratings steps down from AAA, but each step will raise the risk pricing of the security, and many companies, like insurance companies, are limited to holding highly rated debt, often greater than or equal to Baa level.
U.S. debt is widely used as collateral, or to make payments. Foreign investors and governments hold about one-third of our debt.
Many contracts are denominated in dollars. Our debt has been generally treated as risk-free. Missing a payment would probably change that. It could lead to substantially higher borrowing costs not only for the U.S. government but also all connected agencies (i.e., government-sponsored enterprises, like Fannie Mae).
Missing payments is also likely to lead to some companies, firms and banks to not be able to make their own payments because they were counting on this cash. The situation could become even more dire if the bond market then freezes up and people cannot sell certain maturities of U.S. debt that they are holding.”
The crisis is unprecedented; the fallout is unknown
“We have had this sort of crisis before, for example in the early years of the Obama Administration. But then Obama and Boehner were able to come to an agreement and avoid any missed payments.
If we ended up missing a payment, I think that everyone is very uncertain about what would happen next. Most experts would say that they expect there to be a significant reduction in the stock market, possibly well over 20%, and probably a recession, coupled with quite a bit of chaos in the financial markets. These problems would not be contained just to the U.S.
This is truly a self-made disaster. Our lawmakers approved the taxes and spending decisions that got us here and defaulting, even temporarily, could lead to a worldwide recession.
It’s like a household. We made decisions about our earning and what to spend, and now our credit card bills are coming due. I guess we’re saying we aren’t going to pay them? These lawmakers are leaving us in the midst of a crazy mess.”