The following is an economic "case" made by Treasury for the dangers associated with the debt ceiling brinksmanship. While they do admit that there was more to the story in 2011, it far from an objective report. The reality is that the sovereign debt crisis in Europe and unprecedented shift in FOMC policy were the two primary sources of volatility in the summer of 2011, though the fiscal brinksmanship did play a smaller, yet noticeable role. This report focuses exclusively on the latter.
Economists and others have been
warning for weeks that a failure to raise the debt ceiling and the nation's
first-time-ever default on its debt would probably result would have a catastrophic
outcome. The U.S. Treasury today issued
a report, The Potential Macroeconomic Effect of Debt Ceiling Brinksmanship that looks at the possible impact that
merely a close call might have on the economy.
An actual default, the report
says, could cause credit markets to freeze, the value of the dollar to plummet, and
U.S. interest rates to skyrocket, potentially resulting in a financial crisis
and recession that could echo the events of 2008 or worse. But an actual failure
to raise the ceiling and/or a default aren't the only things that Treasury is
"As we saw two years ago,
prolonged uncertainty over whether our nation will pay its bills in full and on
time hurts our economy," Treasury Secretary Jacob J. Lew said. "Postponing
a debt ceiling increase to the very last minute is exactly what our economy
does not need - a self-inflicted wound harming families and businesses. Our
nation has worked hard to recover from the 2008 financial crisis, and Congress
must act now to lift the debt ceiling before that recovery is put in
The Treasury report looks at the
events of 2011 when it appeared that Congress might not raise the debt ceiling
and the fallout that resulted to determine what might happen if the country
comes that close to the cliff again.
Even though Congress did raise
the ceiling in August 2011, before the extraordinary efforts of Treasury to
shift funds around and delay default were exhausted, the U.S. Debt was
downgraded from its historic AAA level, the stock market fell, measures of
volatility jumped, and credit risk spreads widened noticeably. These effects persisted for months and while
other factors played a role, the debt crisis uncertainty took a toll. This time there is the additional problem of
the October 1 government shutdown which, if protracted, could weaken the
economy, making it more susceptible to effects of a debt ceiling impasse.
From June to August 2011 consumer confidence fell 22 percent and business
confidence by 3 percent.
A good deal of household wealth is held in financial
assets, and the S&P 500 index of
equity prices fell about 17 percent in the period around the debt limit debate
and did not recover until into 2012.
About half of US households hold stocks directly or indirectly and between
the second and third quarters of 2011 household wealth fell $2.4 trillion. Lower
household wealth usually leads to a decline in consumption spending and the
loss in stock value reduced retirement savings by $800 billion as well.
Businesses are also affected by stock prices because they rely on both debt and equity financing. When stock prices
fall, investment or other spending to expand
a business is more costly. The effects on households and businesses, moreover, are reinforcing. Less capacity and willingness of households to spend, when businesses
have less incentive to invest, hire, and expand
production, all lead to weaker economic activity.
One measure of volatility or uncertainty in financial markets is the VIX
which measures the implied volatility of stock prices. The VIX roughly doubled in the summer of 2011
and remained elevated for months.
Greater volatility can lead investors to pull back from any investment
perceived as risky which can lead to an increase in the cost of borrowing for
households and businesses. It can also
cause a pullback in spending while individuals and businesses build a cash
buffer against feared future adverse developments.
Corporate risk spreads often indicate
how willing investors are to lend to nonfinancial corporations and imply a
higher cost of borrowing for a given level of Treasury rates. In 2011 corporate risk spreads on BBB-rated
corporate debt jumped 56 basis points and the wider spreads persisted into
2012. Again, this was partially due to
the European debt crisis and the adverse effect on business was muted a bit
because the total cost of borrowing did not rise in line with the wider
spreads. With Treasury yields rising
this year, widening spreads would lead to an increase in yields on corporate
debt. While this is most applicable to
large institutions, in times of stress banks tighten terms and loans to small
businesses as well.
Like Corporate risk
spread, the spread of mortgage rates over Treasury securities reflect investors
willingness to finance mortgages which also involve risk. An increase in risk aversion leads to a
widening of mortgage spreads and can increase rates for a given level of Treasury
leads, raising the cost of buying a home.
Higher rates also reduce the efficacy of refinancing to improve cash
flow which in turn restrains consumption spending.
In the late
summer of 2011 the 30-year fixed-rate conventional mortgage spread jumped by as
much as 70 basis points and this lasted again into 2012. At that time concerns over European sovereign
debt pushed down Treasury yields so mortgage rates actually declined but if those
some widening spreads were to take place now when Treasury yields have been
rising, the report speculates the result would be higher mortgage rates that would restrain the housing market and household
Real GDP expanded at a 1.8 percent annual rate in the first half of
this year and the consensus forecast of private-sector economists last month
was a 2.4 percent acceleration of real GDP in the second half and 2.8 percent
further growth in 2014. As the economy
strengthens, labor market conditions should also continue to improve. The current shutdown puts that outlook at
Private sector economists have estimated that a one-week shutdown could
slow GDP growth in the fourth quarter by over a quarter percentage point with
the effect growing with the length of the shutdown, perhaps even throwing the
country into recession. "If such
projections prove accurate, the weaker-than-expected economic expansion would
be even more susceptible to the adverse effects from a debt ceiling impasse
than prior to the shutdown."
protracted debate over the debt ceiling could spark renewed stress in financial
markets and a fall in stock prices and wider credit spreads which would depress
private sector spending. Increased
uncertainty or reduced confidence could lead consumers to postpose purchases
and businesses to postpone hiring and investments. The report says a precise estimate of the
ultimate effects is impossible and there are different conditions now than two years
ago, "Yet economic theory and empirical
evidence is clear about
the direction of the effect: a large, adverse, and persistent financial shock like the one that began in late 2011 would result in a slower
economy with less hiring and
a higher unemployment rate than would otherwise
be the case."
Indeed there are
already some tentative signs that the current debate is affecting financial
markets. The price moves are small and
could easily reverse but yields on the Treasury bills that mature at the end of
October are higher than those maturing shortly before or after. This might suggest concern about the possible
delays in those bills being paid. If market participants lose confidence in the
country's willingness to pay its bills the adverse effects seen in 2011 could
reappear, even push up yields and raise the cost of financing the government's
debt and worsen the fiscal position of the government.
The report concludes that should there
be a default it could have a catastrophic effect on the financial markets but
also on job creation, consumer spending, and economic growth; maybe even leading
to events of the magnitude of late 2008.
"Considering the experience of countries around that world that have defaulted on their debt, not only might the economic
consequences of default be profound, those consequences, including high interest rates, reduced investment, higher debt payments,
and slow economic growth, could
for more than a generation."