The Dominoes of Default

Imagine two scenarios that should be unthinkable but everyone knows are plausible: 1) House Republicans can’t keep their caucus together on a debt limit vote before the Treasury Department's September 29 deadline; 2) or, come December, President Trump refuses to sign the debt limit increase Congress sends to his desk over a border wall or some unmet demand. What happens next in this previously unseen terrain?

Breaching the debt ceiling would be more harmful to the U.S. economy than the 2008 Lehman Brothers collapse, according to S&P Global’s chief economist.¹ First, with its ability to take on higher levels of debt fully exhausted, Treasury does its best to pay its bills with the little cash it has left on hand and the revenue it has flowing in. But on October 2, 2017, big bills for Social Security, military and civil service benefits, and interest payments come due—to the tune of $117.9 billion.² Millions of Americans won’t get paid. A market panic, media frenzy, and public uproar would be well underway. Making matters worse, federal aid wouldn’t be able to reach victims of Hurricane Harvey, as Treasury Secretary Steven Mnuchin has already warned.³

For a time, to stave off a full-fledged crisis, Treasury ensures bondholders get paid. But even that strategy could fail. Shaken confidence in the government’s ability to repay what it owes means investors will demand higher interest. And some investors may not show up for Treasury auctions altogether. That could prevent Treasury from simply replacing old bonds with new ones, or “rolling over” its debt.⁴

If that happens, the U.S. could default for the first time in its history.

The consequences of default would be massive and would reach every corner of the U.S. economy. In fact, it could be enough to push the U.S. into a recession, as Barclays predicts.⁵ The closer we get to default, the greater the consequences on federal spending, consumer confidence, and private sector activity.

Below, we explore the five most tangible effects of default for middle-class families and Main Street businesses in the U.S. Because we have never defaulted, these projections are inexact. We do know that some effects would begin before an actual default, when the possibility of one seems to rise. All effects would be worse the longer the default drags on, and the damage could vastly exceed what’s projected here.

Domino Effects: Five Consequences of Default

1. Treasury bond rates rise.

The U.S. government does not collect enough in taxes to operate, so it must take on debt and sell bonds. Typical buyers of bonds are institutional investors (like pension funds), foreign countries (often sovereign wealth funds), and individuals (usually through mutual funds and 401(k) accounts).

U.S. government debt is the most relied upon asset in the world given its enormous size, liquidity, and transparency. Treasury securities are one of the lowest cost and most widely used forms of collateral for financial transactions. Investors believe that U.S. debt is “safe” because historically there’s been virtually no chance that the United States government would ever default on these loans. In fact, Treasury bonds are considered to be as safe as cash throughout the financial sector. As a result, Treasury bonds pay a very low rate of return, commonly referred to as the “risk-free rate.” Low risk means low interest rates.

If the government defaults, credit rating agencies would downgrade the rating of Treasury bonds. In 2011, the mere threat of default prompted the credit rating agency Standard & Poor’s to downgrade the U.S. from its AAA rating to AA+ for the first time in 70 years.⁶ And already, Fitch has threatened to downgrade the U.S. if an agreement isn’t reached in time.⁷ A downgrade by all of the big three rating agencies—S&P, Fitch, and Moody’s—would mean the U.S. would have to raise the interest rate it offers for these bonds in order to get investors to continue buying them. This is because their number one draw—a risk-free investment—would now be a fallacy.

Default would thus mean the cost of borrowing for the U.S. government would increase, perhaps dramatically.

• In 2011, J.P. Morgan and PIMCO estimated that a default would lift the rate on Treasuries by half a percentage point (0.5%).⁸ Additionally, the 2013 debt ceiling scare showed that Treasury rates could rapidly rise by that amount even without an actual default. A Government Accountability Office report concluded that the threat of default in 2013 catapulted market yields on U.S. Treasuries from 0.01% to 0.5%.⁹
• J.P. Morgan estimated that higher Treasury rates would cause our GDP to decrease by 1%.¹⁰
• For every 1% decrease in GDP growth, there is an estimated 0.5% increase in the unemployment rate, according to an economic concept known as Okun’s Law. Using this estimation, the U.S. would shed approximately 800,000 jobs—the equivalent of the last five months of job growth.¹¹

To be clear, this is a conservative estimate as default is a “black swan” event that has no American precedent.

2. The stock market drops and 401(k)s take a dive.

A Treasury report on the macroeconomic effects of approaching the debt ceiling found that 2011’s debt ceiling debacle led to a 17% decline in the S&P 500 index.¹² What if that happened again? Using some straightforward assumptions, this would be the impact be on a typical 401(k) retirement fund:

• According to the Employee Benefit Research Institute’s analysis of 2015 balances, the typical 401(k) of an investor in their 50s contains $223,451.¹³
• U.S. equities, like those in the S&P 500, represent 39% of an example lifecycle fund targeting retirement in 2025.¹⁴
• A 17% loss in the S&P 500 would cost this portfolio about $15,000.

With approximately 54 million U.S. workers invested in 401(k) plans, these losses would hurt households in every American community.¹⁵ And unlike in 2011, the likelihood of a recession would be high, making the market unlikely to bounce back quickly.

Another possibility would be that fire sales ignite throughout the financial markets. If investors start selling assets, prices will go down in a death spiral on all types of securities, including stocks, bonds, and real estate. We have had recent experience with mass liquidation during the financial crisis. From July 2008 to March 2009, the U.S. lost $7.4 trillion in stock wealth or nearly $66,200 per household.¹⁶

3. Mortgage rates rise.

The rate that Americans pay for a mortgage is generally tied to the interest rate on Treasury bonds. Since the end of the 2007-2009 recession, 30-year mortgage rates have been 0.76% higher than 30-year Treasury bonds, on average.¹⁷ The difference between these two rates is known as the “spread.”  During the 2011 debt ceiling crisis, the spread on mortgages increased by an additional 70 basis points, or 0.70%.¹⁸ That makes mortgages cost more than they would in less volatile financial conditions.

If that happened again, what would this mean for the average homebuyer?

• At the end of August 2017, the average 30-year mortgage interest rate was 3.86%.¹⁹
• A 0.70% interest rate increase from 3.86% to 4.56% for a new 30-year fixed mortgage would immediately add approximately $38,000 to the lifetime cost on a median home loan of $256,080 (assuming a 20% down payment on a home valued at $320,100, the median U.S. home sale price from July 2017).²⁰

4. Small business and consumer credit tightens.

Once the dominoes of default—rising Treasury bond rates, declining stock markets, rising mortgage rates— begin to fall, lending to small businesses and consumers will constrict.

Why would lending tighten? In short, there would be less money made available to people and businesses to borrow (i.e. far less liquidity).

This liquidity shortage would be a direct result of uncertainty and volatility in the markets. When there is economic uncertainty and volatility, credit gets squeezed because banks want to keep as much money in reserve as they can.

What credit is still available would be costly because banks would increase their interest rates on loans. Small business owners would have a difficult time getting a loan from their bank for start-up costs or business expansion—or they would have to pay rates that they simply could not afford.

Consumers would have trouble securing a car, student, or personal loan. Credit card rates—which are also tied to Treasury rates—would rise, making purchases more expensive and resulting in depressed retail sales. Less spending by consumers and small businesses could help send the economy into a recession.

5. The dollar loses its “special status.”

In many ways, the U.S. dollar is just like any other commodity that is bought and sold. When there are more sellers than borrowers, its price and status drops.

Foreign holdings of U.S. dollars are enormous, because the dollar is the world’s “reserve currency.” Countries keep trillions of American dollars in reserve in case of economic or national security emergencies. For example, China has $1.15 trillion and Japan has $1.09 trillion in reserves.²¹ If a foreign government undergoes an economic upheaval, it can dig into its reserve of American dollars and weather the storm. According to the International Monetary Fund, the U.S. dollar’s share of other countries’ official foreign exchange reserves has held steady around 60-65% since the financial crisis.²²

But political and economic volatility in the form of a U.S. default would compel investors to sell some of their holdings. According to The Economist, “The defeat of proposed legislation, the election of a particular politician or the release of an unexpected bit of economic data may all cause a currency to strengthen or weaken against the currencies of other countries."²³

A U.S. default may convince institutional investors and sovereign wealth funds that the dollar is not where their reserves should be kept. Currency reserves can be revoked; the British pound was formerly the dominant currency for trade, but the dollar became the currency of choice after the U.K. amassed a huge debt due to the costs of World War I. Even without the threat of default, many economists argue that China’s currency—the renminbi—is on its way to challenging the dollar, according to a previous Third Way report. A default would hasten China’s challenge and increase the odds that the renminbi actually overtakes the dollar. Recent history shows economic events in the U.S. can prompt other countries to adjust their reserve holdings, according to a 2011 J.P. Morgan report. For example, the 2008 economic downturn led other countries to decrease their holdings of Fannie Mae and Freddie Mac debt.²⁴

If investors liquidate their holdings of U.S. dollar assets, the value of the dollar would decrease and inflationary pressures are likely, though not certain, to occur. The “flight to safety” that has strengthened the dollar during recent bouts of turmoil in the European Union could be reversed if we face our own economic upheaval.

What might that mean on Main Street? On the one hand, if the U.S. dollar loses its “special status” and the value of the dollar decreases, exports like commercial airplanes and computer chips become cheaper. The downside is more significant. Not only would imports like oil and electronics become more expensive, but there would also be additional upward pressure on borrowing costs, making it even more expensive to take out a mortgage or a business loan.

Conclusion

Before President Trump struck a deal with Senate and House Democrats to avert the September 29 debt ceiling deadline, Goldman Sachs predicted a 1-in-3 chance that the U.S. government would default.²⁵ But there's no guarantee that House Republicans will go along with this plan, or that they or President Trump won't try to play a game of chicken when the next deadline in December approaches. If the U.S. defaults, it will have done so by choice, effectively inviting an economic crisis. Washington could quickly correct its course, but if markets have lost faith in the U.S. government, it could be too late. Even a brief default could throw so much sand in the gears of our economy that another much worse scenario might play out—including the looming possibility of a recession.

Everything from missed Social Security payments to increased costs of mortgages to losses in 401(k)s would mean average Americans will eventually have to deal with the consequences. Policymakers must come to the table and figure out a solution before the dominoes of default begin to fall.

This paper is an updated version of the previous reports ”The Dominoes of Default” and “The Dominoes of Default, 2013,” authored by Jim Kessler and Lauren Oppenheimer, and ”The Dominoes of Default, 2015,” authored by David Brown and Tanner Daniel.