July 15, 2021

How the Lack of Action on the Debt Limit Can Hurt the Economy

As Washington policymakers approach a critical deadline for the debt limit (also known as the debt ceiling), there are significant risks for the economy. Even if Congress raises the debt limit and avoids default, last-minute brinkmanship alone has the potential to create economic damage.

What is the debt limit?

The debt limit refers to the maximum amount of debt that the Treasury can issue to the public and to internal government accounts. It does not authorize new outlays; rather, it sets a limit on borrowing to pay for spending that Congress and the President have already approved.

On August 2, 2019, policymakers suspended the debt limit through July 31, 2021. When the suspension period ends, the maximum amount will be reset to the amount of debt outstanding at the time — which will leave the Treasury with no space for further borrowing. At that point, the Treasury will begin using “extraordinary measures” to continue raising funds without breaching the limit. Those types of measures are specified by law and, according to the Bipartisan Policy Center, are projected to run out some time in the fall.

What happens if Congress doesn’t raise or suspend the debt limit?

Lawmakers have to act before extraordinary measures run out to avoid serious economic and budgetary consequences. If the Treasury runs out of extraordinary measures, it would only have incoming revenues at its disposal. Since the federal government is currently running a large deficit, incoming revenues will not be nearly sufficient to cover all payment obligations. Without the ability to close that gap through borrowing, Treasury would have to somehow determine when payments would be distributed for the wide range of government activities.

Without an increase in the limit, worries about the government’s creditworthiness would ripple through global financial markets. Investors would likely demand a higher return on debt issued by the federal government. In turn, the government would have to pay more interest on its debt, which would create a further strain on future budgets.

There would also be broader economic consequences. A 2013 paper by Macroeconomic Advisers found that if Congress had failed to address the debt limit in 2013, the economy would have entered a recession. The unemployment rate would have risen, and 2.5 million jobs would have been lost. And if the impasse had extended for two months, job losses would have been even more severe.

Are there still negative consequences for waiting until the last minute to address the debt limit?

Yes. If Congress addresses the debt limit — even at the last minute — the effects would not be as harmful as the scenario described above. However, last-minute fiscal brinkmanship could still have significant negative consequences. Even though the government has never defaulted on its principal and interest payments, the continued pattern of brinksmanship is a periodic source of anxiety to financial markets, threatening our credit rating, increasing interest rates, and causing measurable damage to our economy.

A paper from the Federal Reserve suggests that waiting to address the debt limit cost the federal government $260 million in 2011 and $230 million in 2013 because investors demanded a higher return on Treasury bills as it got close to the time at which the Treasury would run out of borrowing authority. In fact, the bills that saw the highest increase in yield were those that matured on dates soon after the projected point at which Treasury would run out of cash, demonstrating that some investors recognized the risk that interest payments could be delayed or canceled.

In addition, credit rating agencies can respond by downgrading their ratings for United States debt. In 2011, when Congress delayed addressing the debt limit until the last minute, S&P lowered their long-term sovereign credit rating for the United States from AAA to AA+. S&P’s rationale gives valuable insight into the market’s perception of delayed action on the debt limit:

The political brinkmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy.

Conclusion

While the debt ceiling itself is not an effective check on our unsustainable national debt, failure to address it does represent a threat to our economy. Governing by crisis, engaging in fiscal brinkmanship, and risking our nation’s creditworthiness are not efficient means of addressing our nation’s fiscal challenges. Instead of putting our economy at unnecessary risk, lawmakers should focus on a long-term plan to address the structural mismatch between spending and revenue, in order to put us on a more sustainable fiscal path.


Related: Infographic: What Is The Debt Limit?


Image credit: Photo by stockvisual/Getty Images

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