When it all falls down: A debt ceiling disaster scenario

Sen. Richard Durbin (D- Ill.) speaks to reporters after voting on the debt ceiling July 31, 2011 in Washington, D.C.

The government shutdown is only three days old, yet a bigger battle already looms: raising the debt ceiling.

The Treasury Department on Thursday released a report warning that breaching the borrowing limit on October 17 could have dire economic consequences. The last time the U.S. government squabbled its way towards even the possibility of defaulting, it stung the economy.

“The stock market went down, it got more volatile, there were effects on consumer confidence,” says Alice Rivlin, a senior fellow at the Brookings Institution.

The S&P 500 fell 17 percent, U.S. debt was downgraded and job growth slowed. It took months to recover. 

“It was a serious situation even though we didn’t default, we just talked about it,” Rivlin says.

But it’s hard to say that that same thing will happen again, because other stuff was going on at that time.  

“The thing that people lose track of a little bit is that that’s really kind of the time when the eurozone starts falling off the cliff,” says Bill Stone, chief investment strategist for PNC Wealth Management.

That also may have hurt the stock market.  On the flip side, though, Europe looked so bad compared to the U.S. that investors flocked to Treasury bonds, even after they had been downgraded following the the debt-ceiling battle.

And investors are doing the same these days. So if people take the possibility of a default seriously, says Stone, “It’s odd that the flight to safety flies to the thing that people are worried about. Treasury yields are actually down.” 

That’s because investors can’t fathom that Congress would do something so insane as to let the U.S. default on its obligations, says Steve Blitz, chief economist with ITG. 

“Every financial institution in the world has their capital in U.S. Treasuries,” he says. “This thing runs through everything.”

Brookings’ Rivlin says while the current economic situation may be better, the political situation is worse. 

“The consequences are even more dire than 2011 because the government is shutdown, the atmosphere is so bitter and financial markets might take more seriously that the United States is seriously flirting with not paying its bills,” she says. “I don’t think the world took us very seriously in August of ‘11.  At some point we will be taken seriously and then the crisis could be dire.”

Even if it doesn’t come to that, there is still a risk.

“The real issue is: What does the deal look like that gets government back to work, that raises the debt ceiling,” says ITG’s Blitz. 

There could well be some kind of brutal compromise that cuts government spending deeply or randomly, like last time around. 

“That’s the critical thing. That’s what we’re going to live with,” Blitz says. “If it is a deal that is a little bit too draconian, it’s going to slow the economy.”

So not only would failing to raise the debt ceiling by October 17 hurt the economy, and not only might arguing over raising the debt ceiling hurt the economy, but even resolving the debt ceiling problem could hurt the economy.

About the author

Sabri Ben-Achour is a reporter for Marketplace, based in the New York City bureau. He covers Wall Street, finance, and anything New York and money related.

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