Political turmoil and the threat of default in the United State are raising concerns about the disastrous effects that a lowering of the U.S. credit rating would have on the world economy. Even talking about not raising the debt limit and risking default has economic consequences that impact consumer sentiment and spending.
The debt ceiling was created in 1917 during World War I to restrain spending; it limits the amount of bonds that the U.S. can issue. It has routinely been raised since then, and has been raised 14 times from 2001-2013 between Presidents Bush and Obama. In comparison, President Reagan requested it be raised 18 times during the 1980s. Congressional Republicans are refusing to raise it again unless a list of demands is met - several of which have absolutely nothing to do with spending or debt.
The irony is that the debt ceiling isn't an effective tool to lower government spending, according to Northwestern University Kellogg School of Management finance professor Janice Eberly. "What the debt ceiling doesn't do? - alter spending or the budget deficit. The budget deficit has fallen faster than forecast and continues to drop. Raising the debt ceiling doesn't change that downward path - it just allows us to pay out what has already been promised by legislation," she said in an e-mail.
Here's a list of what financial experts say could happen if the U.S. defaults:
1: The U.S. government won't make its payments
"...Businesses and individuals that have contracts, businesses, and jobs with the government, social security and Medicare recipients, the military, state and local governments [could miss on-time payments]. The government has obligations of hundreds of billions of dollars each month, and individuals and businesses around the country rely on these payments," Eberly said.
This would have the effect of raising serious questions around the world and in financial markets about the U.S. government's ability to govern.
"We face challenges that require the hard, patient work of thoughtful leaders," Eberly said.
2: Unusual concern about typically-safe Treasuries
"The Treasury market is part of the bedrock of the financial system. The stability and safety of the securities issued by the U.S. government benefit both the investors who hold them and taxpayers who can borrow more cheaply because this debt is trusted as safe and liquid. And because Treasuries are so central, there is real concern about spillovers to other financial markets and interest rates," Eberly said.
Other financial experts that I spoke with off the record suggested that a loss of confidence in T-bills could ignite a global economic collapse that would significantly eclipse the 2007 financial crisis. Theoretically, the following would happen as a U.S. default ripples through the global financial system:
- Most large financial institutions (banks, insurance companies, pension funds) would be forced to replace investments in AAA securities (basically treasuries), and replace that collateral with equivalents. These institutions would have to liquidate trillions in holdings because of lack of compliance, creating massive worldwide instability.
- U.S. towns and cities would be forced into bankruptcy.
- Pensions would be severely impacted with the U.S. dollar no longer being worth a dollar.
- Ultimately, a deflationary period would begin.
3: Falling consumer confidence would slow down the U.S. economy
"The debt ceiling drama in 2011 drove consumer confidence down by an amount you would typically see in a recession," Eberly said. This has a real impact on the economy. Businesses have already expressed concerns:
"The CEO of Lexus was on CNBC [Thursday] morning and he made it very clear that consumer confidence will be shaken by Washington's theatrics. He said it will directly affect their top line," said Opinicus wealth manager Griffin Dalrymple.
Advertising executive Mike Poller has been a small business owner for over 25 years. He's faulting Washington's dysfunction for a slowdown in the car sales business.
"I see sales seize up at my car dealer clients whenever there is foot-dragging in DC. People are wary about taking on debt (car or mortgage) when DC can't seem to get its act together," he said.
4: Lower near-term interest rates in the U.S.
This one isn't necessarily bad if you're buying a car, house, making variable rate student loan payments, or building things. The cost of money will be low for a while.
"In the near term, I don't foresee any adverse effects to interest rates aside from the expected volatility due to a government debt default. I believe inflation and economic improvement are the hot games in town dictating interest rate movements at this time. In fact, I'll play the contrarian card and state that low interest rates will be here to stay even longer than 2014, due to the economic hangover of a U.S. debt default and the consequential flat unemployment rate," Opinicus's Dalrymple said.
5: A choking rise in interest rates and dwindling U.S. government services
"Ultimately, the long term consequences of a U.S. debt default will be the true burden we all bear ... World faith in the U.S. Government's ability to pay their liabilities will continue to dwindle due to a gridlocked political environment. In turn, U.S. interest rates will begin to increase which will also increase the percentage of government revenues applied to debt servicing," Dalrymple said.
6: Higher taxes in the U.S.
"This [rise in debt servicing] will stoke politicians to seek alternative revenue streams to subsidize their growing government handout programs and overall operation. The dollars will be squeezed from the consumer in the way of a VAT tax or increased taxes on the small business owner," Dalrymple said.
7: A loss of entrepreneurship and U.S. brain drain
"Eventually, the risk reward ratio for entrepreneurs in America will be stifled by equality programs and taxes, innovation will plummet and talent will move elsewhere to be compensated for their ideas," Dalrymple said.
8: Longer-term high unemployment in the U.S.
"American small businesses, companies with less than 500 employees, account for 52 percent of all U.S. workers, according to the U.S. Small Business Administration (SBA)," Dalrymple said. "Bottom line, small business owners will not hire new employees if economic growth is in question."
(image credits: dailymail.co.uk, commondreams.org)