Can a Debt-Limit Fight Really Cause Recession? The Risks Aren’t What You Think.

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About the author: Christopher Smart is chief global strategist and head of the Barings Investment Institute, and is a former senior economic policy official at the U.S. Treasury and the White House.

Let’s stipulate that the “debt limit” is a quaint legal relic that has morphed into a self-defeating political cudgel. Failing to raise the debt limit later this summer would undercut Washington’s global leadership, tarnish its political model, and fuel Beijing’s narrative that the U.S. is a superpower in decline.

But would it really trigger a “massive recession” and “put us in a hole for a long time,” as President Joe Biden warns? Would it be “devastating” to banks and the economy, as Treasury Secretary Janet Yellen suggests? Would it set off a chaotic global flight from the dollar and raise America’s borrowing costs forever? It’s actually not certain how bad the damage might be beyond injecting new volatility into the markets. But what’s crystal clear is that if the administration’s rhetoric proves exaggerated, it will embolden political rivals the next time around to force a much more damaging standoff. 

Having just lived through the largest one-day slump in 2-year Treasury yields since 1982 with the failure of a bank even most savvy investors could not name, it sure feels like the current market turmoil could easily morph into something larger. 

Still, the next scheduled crisis seems unlikely to be a full-blown calamity precisely because it’s scheduled. Not only do we know a debt-limit “crisis” is coming, but we also know that it’s largely for show. Everyone of every political stripe believes America’s debts should be honored. Washington is not refusing to pay, it’s just refusing to borrow.

If you own Treasuries, will you really rush to sell them if you’re certain you’ll be made whole? Moreover, if you do sell the most liquid securities in the world, what will you buy instead? 

For background, the debt limit was first passed in 1917 as a convenience to a Congress that had earlier authorized not just the amount of each new debt issuance, but also specified interest rates and maturities. The more recent practice of using this vehicle to extract spending cuts from a president dates to 1995, when the standoff between House Speaker Newt Gingrich and President Bill Clinton ended in a weeks-long government shutdown. 

It’s also not entirely true that the U.S. government would be entering unprecedented territory by not paying its debts on time and in full.  Following the War of 1812, lagging revenues left the government unable to pay its bills, and in 1933 the Roosevelt administration canceled bond clauses that had promised to pay interest gold. A computer glitch in 1979 led to delays in the processing of 4,000 interest checks due individual bondholders. 

This time around we are already several weeks into a period of Treasury taking “extraordinary measures” to keep its spending under the current limit of $31.4 trillion, including through adjustments to government employee pension funds. But by late summer, “X day” as it is called, will arrive. Unable to borrow more, Treasury won’t have enough to pay all its bills. Neither the Republican House nor the Democratic administration has any incentive to agree to anything much before the last minute. 

Treasury says it has no authority or ability to prioritize retirees over defense contractors or bondholders over government salaries. A government report on a prior debt limit standoff found that Treasury would have paid whatever obligations that came due as soon as there was enough cash on hand, likely triggering an escalating backlog of late payments.

It may strain credulity that Treasury wouldn’t pay bondholders first, but the question remains just how much damage would come from a few days of missed interest payments. Ratings agencies might downgrade U.S. debt—again, it wouldn’t be the first time—but regulators would likely waive any requirements that might trigger a forced sale of the world’s most liquid asset. Short-term bills would see the biggest disruptions, but the Federal Reserve has proven tools to maintain order in money markets.

If the world were just, then markets would indeed punish the U.S. for failing to pay its debts and demand higher interest rates until confidence returns. But financial markets are hardly known for “justice” and the fact remains that a few days’ standoff between the White House and Congress will do very little to affect expectations that the U.S. will in fact pay. Recall that when Standard & Poor’s downgraded U.S. debt following the 2011 standoff, the world’s most liquid assets actually rallied. 

Of course, there are a great many hidden elements in the global financial plumbing that could make the outcome much worse, but the base case should still be a brief period of market disruption that ends with a fiscal deal. 

And that’s the real problem investors should worry about.

Sadly, this will not be the last debt limit stand-off. A relatively benign outcome will only embolden those in Congress who may believe that it will take even more disruption to draw attention to their concerns. The greatest danger comes when not only breaching the debt limit and “extraordinary measures” are tradition, but blowing past ‘X-day’ turns into a regular pattern. That’s when a few days of market disruption turns into a few weeks. 

It may not come with the next debt limit fight or the one after that, but one day bondholders will gradually start looking for compensation and search for alternatives. That’s when the damage to America’s credit and the cost to its taxpayers could become permanent.

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