What to Expect in the Event the U.S. Defaults on Its Debt
The United States is facing a dire situation as it approaches the debt limit and the Treasury Department scrambles to conserve cash. The possibility of a U.S. default, once considered unthinkable, is now looming on the horizon. The potential consequences of such an event are far-reaching and could have devastating effects on financial markets, businesses, and the global economy as a whole.
While lawmakers assure the public that a deal will be reached to raise or suspend the debt limit, the countdown to the day when the U.S. runs out of funds to pay its bills is causing anxiety among investors, executives, and economists worldwide. They are now engaging in contingency planning and attempting to understand the untested rules and procedures that would come into play in the event of a default.
The implications of a prolonged default, lasting weeks or more, could be catastrophic. The White House Council of Economic Advisors issued a report in October 2021 outlining the potential consequences, including a global recession, frozen credit markets, plummeting stock markets, and mass layoffs worldwide. The real gross domestic product (GDP) could plummet to levels not seen since the Great Recession.
It is important to note that the only previous instance of a U.S. default, which occurred in 1979, was an unintentional error that was promptly rectified. The distinction between an inadvertent administrative glitch and a deliberate default resulting from Congress's failure to raise the debt limit is crucial for global markets.
In the event of a default, there would likely be two stages of impact. Initially, payments to Social Security recipients and federal employees could be delayed. Subsequently, the federal government would be unable to service its debt or pay interest to bondholders. U.S. debt, in the form of bonds and securities, is sold to private investors, corporations, and other governments. The mere threat of default would lead to market turmoil, with decreased demand for U.S. debt, downgraded credit ratings, and a spike in interest rates. To entice investors to bear the increased risk, the U.S. would need to offer higher interest payments on its debt.
One significant consequence of a default would be a massive sell-off of U.S. debt, which is widely regarded as one of the safest and most stable forms of investment. This sell-off would have global repercussions, affecting financial institutions and markets around the world. Money market funds, which invest in short-term, high-quality debt like U.S. Treasury bills, could experience increased volatility, jeopardizing their ability to provide stability to conservative investors.
Furthermore, federal benefits would be delayed or suspended entirely in the event of a default. This includes critical programs such as Social Security, Medicare, Medicaid, Supplemental Nutrition Assistance Program (SNAP) benefits, housing assistance, and support for veterans. While Medicare and Medicaid recipients may not be directly affected, delays in payments to healthcare providers could undermine their willingness to treat patients under these programs.
A default would almost certainly trigger a downgrade of the U.S. credit rating, similar to what occurred in 2011 after a last-minute debt ceiling deal was reached. This downgrade would have severe repercussions on the stock markets, causing them to plummet. The potential for increased market volatility and a run on banks could further destabilize an already uncertain banking environment, leading to potential failures of financial institutions.
The impact would also be felt by borrowers, as interest rates on loans would likely increase. Variable loans, including personal and small-business lines of credit, credit cards, and certain student loans, could see rate hikes. Lenders may also decrease credit lines or tighten lending standards, making it more challenging for individuals and businesses to access new credit.
A surge in credit card rates may be on the horizon, surpassing anything Americans have experienced since the Federal Reserve commenced its rate hikes in 2022. Credit cards already carry higher interest rates compared to many other types of loans, making it even more costly to maintain a balance amidst the current economic circumstances. Individuals burdened with debt and capable of doing so should take proactive measures to eliminate their outstanding balances.
During times of economic distress, it is not uncommon for lenders to slash credit limits, close accounts, or impose stricter credit score requirements for approval. These actions were witnessed during the Great Recession and in the early stages of the COVID-19 pandemic, as indicated by a 2022 report from the Consumer Financial Protection Bureau.
In the wake of a U.S. default on its debts, it is highly likely that mortgage rates would witness an increase. Zillow, a prominent real estate website, projects a potential rise of up to two percentage points by September, before subsequently declining. This would precipitate a significant contraction in the housing market.
It's worth noting that a debt ceiling crisis would not directly impact individuals with fixed-rate mortgages or fixed-rate home equity loans. However, holders of adjustable-rate mortgages (ARMs) may feel the impact of rising rates. Those currently in the fixed period of their ARM could witness an escalation in rates upon reaching their first adjustment. Individuals facing challenges in meeting their mortgage payments are strongly advised to proactively engage with their lenders to explore alternative options and discuss potential solutions with a Housing and Urban Development (HUD)-certified housing counselor, who can assist homeowners in navigating alternatives to delinquency and foreclosure.
Moreover, if the prime rate, which serves as the benchmark for lenders in establishing interest rates for lines of credit, experiences an upswing, borrowers with variable-rate home equity lines of credit (HELOCs) will also observe an escalation in their interest rates.
In the event that the debt ceiling remains unraised, taxpayers may face delays in receiving their refunds, which ordinarily arrive within 21 days of electronic filing. In the case of a government default, late filers risk experiencing prolonged delays in obtaining their refunds.
