What are the grave consequences if the U.S. debt ceiling isn’t increased and the government defaults? What would the Federal Reserve and the Executive Branch do to prevent default if Congress doesn’t act?
Topics covered include:
- What are the potential impacts of a U.S. default on the stock and bond markets, and the overall economy
- What causes the U.S. to have a perennial debt ceiling crisis
- Why it is uncertain when the U.S. government would run out of money to meet its obligations
- What the Biden Administration could do to prevent a default
- What the Federal Reserve could do to prevent a default
- Given the ongoing crisis, should you shift assets from stocks to cash?
Show Notes
The Debt Limit Since 2011—Congressional Research Service
7 doomsday scenarios if the U.S. crashes through the debt ceiling by Jeff Stein—The Washington Post
Why I Changed My Mind on the Debt Limit by Laurence H. Tribe—The New York Times
The Trillion-Dollar Coin Might Be the Least Bad Option by Annie Lowrey—The Atlantic
If U.S. again risks default, Fed has ‘loathsome’ playbook by Ann Saphir—Reuters
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Transcript
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode is 433. It’s titled, “What if the US Defaults on Its Debt? Here’s Why It Won’t.”
Potential Consequences of a Debt Default
This week, Treasury Secretary Janet Yellen reinforced her warning that the US risks running out of cash as early as June 1st, unless Congress raises the debt ceiling, the amount of money that the US Treasury is allowed to borrow in order to meet the US government’s obligations.
The Congressional Budget Office this week warned there is significant risk that the US government would be unable to pay all of its obligations within the first two weeks of June unless the debt ceiling is raised. If the debt ceiling isn’t raised, and the US defaults on its debt, Mark Zandi, Chief Economist at Moody’s, said “It would be a lethal combination. You can see how this thing could really metastasize and take down the entire financial system, which would ultimately take out the economy.”
If you look at other predictions of what could occur if the US government defaults on its debt because Congress didn’t raise the debt ceiling, the stock market could crash anywhere from 20% to 45%, according to some predictions. Interest rates would spike.
Potentially, we would see mortgage rates for home purchases in the US exceed 8%. There are securities that depend on US Treasuries, repurchase agreements, for example.
A repurchase agreement, or repo, is a type of security where typically an institution borrows money, and puts up Treasury bonds as collateral. And the market for repos is huge. And if that collateral suddenly isn’t worth what was thought—because usually, the collateral is US government bonds—then there’s potential repercussions throughout the financial system, throughout what’s known as the shadow banking system, which are institutions that perform bank-like functions but aren’t registered as banks.
25% of the US economy is federal government spending. If that spending stops, it would clearly cause unemployment rates to spike, because many, many people would be laid off from their jobs, and the economy would take a big economic hit.
And ultimately, even if the debt ceiling is eventually raised, defaults are cured, there’s the potential for higher longer-term interest rates because market participants now know that Congress is willing to allow the federal government to default on its obligations. Even if it’s only for a few days or weeks, there’s potentially longer-term repercussions of this.
Now, that’s what could happen. In this episode, we’re gonna see why because the consequences are so dire, it won’t happen. Either Congress will raise the debt ceiling, and perhaps they’ll come to an agreement with the Biden administration to cut some spending as part of that. But if they don’t come to an agreement, there are some things the executive branch can do, and the US Central Bank, the Federal Reserve can do to avoid default on the debt.
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