We consider the current debt ceiling impasse in Washington to be a self-inflicted wound. It puts at risk confidence in the dollar and it threatens a major recession. Moreover, the benefit of the battle — some progress on the budget deficit — will likely be very small. There may be some small spending cuts, but with taxes, entitlements and the military likely off the table, it will do little to put the U.S. on a more sustainable debt path. Indeed, that is exactly the outcome of a similar battle in 2011.
How will the debt ceiling violation impact the economy? There are some things we can say with some confidence. In particular, absent some kind of gimmicky solution, when the debt ceiling is breached, the government will have to balance its budget on almost a daily basis. That is a 6%-plus direct hit to GDP (gross domestic product) for as long as it lasts. Once that constraint is removed we would assume there is a catch-up in spending that more or less reverses the shock.
The other channel of impact is through confidence. Wendy Edelberg and Louise Sheiner of Brookings point out that “worsening expectations regarding a possible default would make significant disruptions in financial markets increasingly probable” and that “such financial market disruptions would very likely be coupled with declines in the price of equities, a loss of consumer and business confidence, and a contraction in access to private credit markets.” We agree: directionally this would be a bad development. And we would add, with likely little or no benefit in terms of improved debt sustainability.
However, quantifying the impact on the economy is another thing entirely. As Edelberg and Sheiner point out, “there is an enormous amount of uncertainty surrounding the damage the U.S. economy will incur if the U.S. government is unable to pay all its bills — it depends on how long the situation lasts, how it is managed, and the extent to which investors alter their views about the safety of U.S. Treasuries. An extended impasse is likely to cause significant damage to the U.S. economy. Even in a best-case scenario where the impasse is short-lived, the economy is likely to suffer sustained — and completely avoidable — damage.”
Assuming the conclusion
Perhaps most important is the question of how long the impasse lasts and whether the shocks quickly reverse when a deal is struck. We know from experience that government shutdowns have not had discernable lasting impacts on the economy. However, a debt ceiling violation is a much bigger shock and we simply have no precedent for quantifying the impact.
What can we say with confidence? While it is very hard to quantify the impact of brinkmanship or a short-term violation of the ceiling, a three-month impasse would likely trigger a major recession, with lasting damage. The contraction in spending alone would cause a recession and clearly the market and confidence effects would be large. It is also likely that the impact is non-linear: the longer the impasse lasts the more likely that any eventual budget deal will not fully reverse the damage.
Under any scenario, we think the debt ceiling battle does a lot more harm than good. It threatens a major shock to the economy, while not addressing the fundamental debt problem. Any deal will have to garner bipartisan support and hence cuts will likely be primarily symbolic. At the same time, the debt ceiling battle is a distraction from the serious business of trying to address the budget deficit. Finally, although the latest news flow suggests that Democrats and Republicans are moving closer to an agreement, more such battles seem likely as long as there is a split government. The only “good” news is that if they go over the limit it will be easier to estimate the shock next time.