Ajay Rajadhyaksha is global chair of research at Barclays.
At some point this summer, the US government will hit its “drop-dead” date: the point at which the Treasury’s extraordinary measures to avoid defaulting on its financial obligations run out.
On that date, the US debt limit will have to be raised, immediately, if the US is to make good on all its spending commitments and servicing its sovereign debt. But given the political schisms in the country, there’s a chance that Congress fails to raise the debt ceiling even on this last possible date. What happens the day after?
The answer might be — surprisingly little, in both the economy and financial markets.
Wait, what? Surely a default on Treasury debt would ricochet across the world? After all, the US government’s creditworthiness is the bedrock of global financial markets. Treasury bonds are quite literally the risk-free security off which everything else is benchmarked. A debt default would throw all of that into question, surely?
Except . . .
In the previous 2011 and 2013 debt ceiling fights, Treasury and the Federal Reserve publicly set out a series of principles they would follow in case of a debt limit impasse. The first was that Treasury would prioritise bond payments.
Officials would forecast future bond interest and principal cash flows and pay bondholders before paying (some of) the nation’s other bills. Where needed, they would hold back a cushion to ensure that they could definitely make any future bond payment. In other words, a debt ceiling impasse doesn’t mean a default on Treasury bonds.
No Treasury secretary is ever going to emphasise this debt priorisation, since it reduces pressure on Congress to raise the debt limit. Moreover, prioritisation sets a very poor precedent, and not just because of the optics of paying bondholders (including foreign nations) over US citizens and businesses.
The approach hasn’t ever been tested and would be operationally complex. In a normal month, Treasury makes thousands and thousands of payments, big and small. And government officials would almost certainly have to hold back more cash than strictly necessary, in order to take no chance on bond payments. This in turn means a sharp, sudden and brutal cuts to all other government spending.
Consider August, which is when the drop-dead date is most likely to be hit. 2019 is a good baseline, since cash flows in 2020 to 2022 were affected first by the pandemic and then by fiscal stimulus. If August 2023 follows the path of August 2019, Treasury will have roughly $200bn in cash inflows and $400bn in cash outflows. But only a small amount of the outlays will be needed for bond payments. Treasury will pay those over the month, hold some back during the process and spend the rest of the $200bn it receives. That means at least $200bn in government spending will suddenly be cut off until the debt ceiling is raised.
Economically, that could be a massive blow. But even here, there is a nuance. Remember, this is spending to which the US government has already committed. This means that the minute the debt ceiling is eventually raised, this money has to be spent — no ifs and buts. That certainty will lessen the initial economic shock.
Say there’s a small business that is about to get a payment from the government. If the money doesn’t come through on the correct date, the business owner is unlikely to panic. He or she will believe that it’s only a matter of time before the government does make good on its bills.
But if days turn to weeks and that payment still doesn’t show up, the owner might struggle to make payroll. Even worse, if they start to wonder if the payment will ever arrive, the business might pull back hard. But this process is a slow build. On the day after the drop-dead date, most non-bond creditors of the US government are likely to think of the process as a payment delay of a few days, not a default. The greater the time that passes since, the more the chance that something “breaks” in the economy.
Financial markets will also follow this logic. The stock market will quiver a bit after the drop-dead date, if the impasse persists. But Treasury bonds will actually rally — the arguments of a general buyer’s strike for US sovereign debt make no sense. It didn’t happen in 2011, including after the US got downgraded, and it won’t happen now either.
This is not remotely an argument to play games with the debt ceiling. Far from it. The spending commitments were decided months and years ago; raising the debt limit is only a way to settle existing bills. And the economic and market consequences will worsen the longer the impasse continues after the drop-dead date. Eventually, markets may even start worrying about the unthinkable — maybe the US truly isn’t going to make good on its existing non-debt commitments?
On the first day after, there is unlikely to be a “big bang”, either in markets or the economy. But if a financial crash doesn’t happen despite months of warnings it might make matters worse by emboldening the holdouts in Congress to dig in further — for weeks if not months.
And that’s when the real damage will start to occur.
