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Investor Panic: Potential Consequences of a U.S. Debt Default Revealed


Eight million is the sobering figure economists urge you to remember. If the U.S. were to default on its debt, the repercussions would be large: a staggering loss of more than 8 million jobs, accompanied by a protracted recession that could span months, if not years. Americans would have to brace themselves for a jarring combination of a stock market crash, depleted retirement and investment portfolios, plummeting property values and even income setbacks for those fortunate enough to retain their jobs.

Though it appears President Biden and House Speaker Kevin McCarthy (R-Calif.) have reached a deal that would suspend the debt limit for two years, the House will vote on May 31 on the Fiscal Responsibility Act of 2023 to try to prevent the U.S. economy from careening into an abyss amid the debt ceiling crisis.

While this likely means that imminent disaster will be averted, many Americans may be wondering why exactly failure to come up with a solution to the debt ceiling crisis could affect their employment status. After all, what connects a bunch of Treasury bonds in Washington, D.C. to someone losing his job in Gary, Indiana?

Here’s how it works.

For more hands-on guidance navigating the nuances of the debt limit question, match for free with a vetted financial advisor.

What Default Means

A government default would mean that the U.S. Treasury has run out of money to pay its bills in full and on time. Instead, the Treasury would selectively pay some bills and skip others as it collects tax revenue. Basically, the process looks like this:

The Budget

Every year, Congress passes a budget that funds the government and all of its operations. This incurs obligations from Social Security benefits to defense contracts, federal paychecks, interest on existing debt, lease payments and more.

The Taxes

As part of the budget, Congress instructs the Treasury to pay these bills. It does so mainly through tax revenue that it collects on an ongoing basis throughout the year. Taxes roll in, cash rolls out and the bills get paid.

The Debt

But, under ordinary circumstances, Congress spends more in the budget than it collects in taxes. To make up the difference, the Treasury borrows money by selling debt instruments called bonds. (To be accurate, it sells notes, bills and bonds, but the main difference is the maturity length of each asset so we will refer to them collectively as “bonds.”) Each bond is a promise to repay the lender after a number of months or years with set interest payments along the way.

The Debt Ceiling

However, in the early 20th Century, Congress also passed a law called the debt ceiling. This limits the total value of bonds that the Treasury can have in circulation at any one time. Once the Treasury reaches this ceiling, it cannot issue new bonds until it pays some existing ones back.

The Default

A government default would occur if the spending that Congress requires exceeds the cash flow that it has authorized. If the Treasury needs to pay some bills, but it has neither the tax revenue nor the borrowing authority to do so, then it will have to leave those bills unpaid. This would harm the government’s credit both formally, in terms of its credit rating, and informally, in terms of its reputation as a business partner.

The Costs of Default

So, if this is what a default is, what does a default do?

Economists have been unambiguous that a U.S. default would trigger an economic catastrophe comparable to the Great Recession or worse. As the New York Times’ Paul Krugman put it, “I hope someone inside the Treasury is quietly preparing to do whatever it takes. If not, God help us all.” The steps that connect the bond market to your job and home are a little more complicated.

As a threshold matter, nobody actually knows for sure what would happen in the case of a U.S. government default. This is because it’s never happened in the modern era. The economy is extremely large and, despite economists’ love for mathematics, it’s a massive psychological and sociological system at heart. People will react to a default unpredictably. But some of the broad contours are relatively well understood.

An Immediate Liquidity Crisis

If the Treasury runs out of money it would selectively prioritize which bills to pay and which to skip. Nobody knows how it would manage this because no regulations provide guidance for a situation both voluntary and catastrophic.

However, this would mean that some people get paid and some people don’t. It’s likely that the Treasury would prioritize existing bondholders, so individuals and institutions holding these assets would keep getting their payments on time. From there, just about anyone who receives money from the federal government might or might not get paid. This would include federal employees, Social Security recipients, government contractors and vendors and more.

By one estimate, if the Treasury pays bond holders in full, it would have to skip about 25% of all other payments. This would mean billions, and eventually trillions, of dollars in missed payments with the problem getting worse depending on how long a default lasts.

For individuals and businesses this would create an immediate liquidity crisis. Every government worker that misses their paycheck might have to skip their rent. Vendors that don’t get paid may not have the cash to make payroll. This would create an ongoing liquidity problem for households, one which would get worse the longer a default lasts.

The Credit Markets

The question of credit is at the heart of a default crisis, and it is very uncertain.

U.S. Treasury debt is the asset on which most of the financial market operates. Investors treat this as the market’s zero-risk asset and price everything else based on that assumption. Effectively, and in some cases officially, this makes the interest rate of Treasury debt the floor for all credit and lending. Any other investment has to beat that, or investors will just park their money in Treasuries and collect the guaranteed return.

A default would introduce risk into the Treasury bond market. Among other problems, investors would demand higher interest rates to buy these now-risky assets, while others would abandon Treasury debt altogether in search of safe investments. This would raise the floor for all borrowing across the board as interest goes up in the now-riskier market.

For individuals, this means higher mortgage rates, higher credit card rates, higher student loan rates and more. It would also mean a collapse in value for anything based on credit, because when the price of borrowing goes up the underlying equity declines. Most notably, this would undercut the housing market, sucking value out of peoples’ homes due to higher mortgage and construction costs.

The Stock Market

Even a brief default would likely trigger a recession. A default that stretches on for several weeks would likely cause the stock market to collapse and inflation to soar.

Much of this is based, again, on the central role that U.S. Treasury debt plays in the economic system. Treasury bonds are the go-to asset for investors who want to park their money. Whether someone is looking for safety or just wants to hold his money in an interest-bearing account while he looks for a new opportunity, he can typically feel comfortable investing in Treasury bonds.

Foreign investors, companies and governments, meanwhile, use Treasury bonds as a way of accessing U.S. dollars. The dollar is the world’s reserve currency, meaning that it’s the currency in which foreign transactions are priced. If two foreign companies do business, they generally price that transaction in dollars and access those dollars through Treasury bonds.

All of this would be undercut by a default. Participants in every market would now price risk into every activity, from holding cash to conducting deals, because there would be no zero-risk segment of the market. This would slow down both investment and business transactions, as both activities get more expensive, causing every section of the market to lose value.

It’s impossible to estimate exactly how severe this would be. For individuals, however, it would almost certainly translate to investment losses. Households would lose significant, potentially enormous, value from their savings and their retirement accounts, and a recovery would likely be slow.

The Labor Markets

Most mainstream estimates find that a default could cost around 8 million jobs. A short default, lasting just a few hours or days, would be less severe, but even that would likely cost hundreds of thousands of jobs. One analysis suggests that the impact could be an unemployment rate of anywhere from 7% to 12% by the end of the year.

Much of the reason for this has to do with borrowing and business disruption. Once risk is introduced into Treasury debt, the cost of credit will increase at every level. At the same time, investors will get less likely to move their money around, as they will have fewer safe assets in which to invest. Combined, businesses will then have much less money to spend, forcing them to slow down their operations.

This would be similar in effect to 2008’s market crash, when a credit crunch forced businesses to slow down economy-wide. Just like in 2008, this would lead to massive layoffs as newly cash-strapped businesses no longer have the money or the customers to pay their workers. This would likely hit large-scale production jobs first, like in construction and manufacturing, since these are areas where customers tend to rely on the most on debt.

Ongoing Ripple Effects

As The Brookings Institute writes, models show that even a brief default would have long-lasting effects. One simulation found that a short (hours or days) default can still lead to a recession and 2.5 million job losses “that only returned very slowly.”

These ripple effects, in part, would be due to the permanent reputational damage U.S. credit would suffer.

The basis of the market for Treasury debt is the idea that these assets are completely safe. That reputation, once lost, cannot be regained. Congress will have introduced the idea that U.S. credit is subject to politics and, if the government can default on its bills once, it can do so again.

That risk will be priced into Treasury debt for years to come, if not indefinitely. The national debt will get significantly more expensive as interest rates climb for future borrowing. Downstream credit, from mortgages to credit cards, will correspondingly creep up. Corporate bonds will do the same, making it more expensive for businesses to borrow and burdening them with higher interest rates on decades-long instruments. The labor market is projected to remain sluggish for years, as higher credit prices slow down business overall.

The exact scope of this is entirely uncertain. It will depend on how markets view a default and how long any default lasts, but some suffering is almost inevitable after even a very brief default.

The good news, however, is that Congress is likely to pass the bill Biden and McCarthy agreed upon.

The Bottom Line

What happens if the U.S. defaults on its bills? It would change the basic assumption that financial markets run on, that Treasury debt is safe, causing a slowdown in cash and borrowing at every level and wiping out value from investments. This would look similar to the 2008 credit crunch, with even worse consequences.

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Photo credit: ©iStock/William_Potter, ©iStock/Douglas Rissing, ©iStock/MCCAIG

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