The last few days have been a reminder of how much uncertainty can stem from systemic risk in the financial system: a fog-of-war atmosphere, stocks plunging and then rising, emergency actions by the Fed and Treasury, the concern that turmoil in the US will spread overseas.

As rough as the last week has been, running up to the eleventh hour to raise the debt ceiling would be even worse.

From my recent testimony:

Brushing up against default would have serious and adverse economic effects. It would lead to reductions in stock prices, reducing the wealth of many taxpayers. It would reduce economic confidence, which in turn could reduce consumer spending. It would increase interest rates, leaving taxpayers on the hook for billions of dollars of interest payments. And it would increase the odds of an accidental default.

On the day before a deal was reached during the 2011 debt ceiling standoff, the S&P 500 was down 6 percent from its high that year. Four days later, credit rating agency Standard & Poor’s downgraded the United States’ credit rating, sending stock prices tumbling further. At its low point during this episode, the S&P 500 lost around 15 percent of its value.

The 2011 debt ceiling standoff sent economic confidence down to levels not seen since the 2008 global financial crisis. This matters because consumers’ outlook for the economy has an effect on consumer spending. When consumers are pessimistic about the economy, they spend less, and since consumer spending is the main driver of the overall economy, consumer pessimism slows overall economic growth.

Even though a resolution was reached in 2011 in time for the U.S. not to miss any payments, the episode still drove up interest rates, costing taxpayers $1.3 billion in 2011, according to the Government Accountability Office.  The ten-year cost was estimated at around $19 billion.

Running up to the eleventh hour runs the risk of the U.S. accidentally missing payments. Accidents can happen. In the spring of 1979, Congress reached a debt ceiling deal at the last minute, but a subsequent computer glitch meant that Treasury was late in making payments on maturing securities to individual investors and in redeeming Treasury bills. Economists Terry L. Zivney and Richard D. Marcus estimate that, as a consequence, T-bill rates at the initial occurrence of the default increased by 60 basis points, and that this increase was not offset by subsequent decreases after Treasury had fixed the default.

Zivney and Marcus conclude: “The default apparently warned investors that Treasury issues were not completely riskless, which translates into a $12 billion annual increase in federal interest payments as a result of the 60 basis point permanent increase in interest rates.”

And, of course, defaulting would be even worse:

Actually missing a payment to a bondholder — actually defaulting, as opposed to running up to the eleventh hour and lifting the debt ceiling in the nick of time — would have consequences that would be much more severe than occurred in 2011 or 1979. The Dow would plunge by thousands of points per day, and the credibility of the United States — its trustworthiness as a country that pays its debts on time — would be substantially eroded. The beginnings of a global financial crisis would take hold as the riskiness of Treasuries increased and market liquidity dried up. After a day or two of this chaos, a clean bill to increase the debt ceiling would pass both houses of Congress with overwhelming bipartisan support.

Staying current on payments to bondholders while not executing other spending — e.g., not paying full Social Security benefits or not funding components of discretionary spending at levels required by law as part of a plan to prioritize payments while not increasing the debt ceiling — would likely provoke a reaction similar to defaulting on U.S. debt obligations. The message Congress and the President would be sending to global markets would be that the U.S. government is unable to meet its spending obligations due to political dysfunction. Among global debt and equity investors, this would shake confidence in the U.S. in a very fundamental way.

There are many lessons to draw from SVB’s collapse. One of them: Congress and the president should not play games with the debt ceiling. The debt limit should be increased or suspended as soon as possible.

The fundamental question at the heart of the debt ceiling controversy. pic.twitter.com/TfAuP8n0Wj

— Michael R. Strain (@MichaelRStrain) March 8, 2023

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