What happens if the US defaults on its debt? (2024)

As a game of chicken plays out in Washington, DC, over whether to raise the limit on US government borrowing to avoid a default on its debt, the one thing that experts agree on is that a default would be catastrophic.

The United States hit its borrowing limit on January 19. Since then, the US Treasury has implemented a number of measures to avoid a default, but it is only a matter of days, or weeks at most, before those are exhausted and the US government is unable to pay what it owes.

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Here’s an explainer on what happens if this unprecedented event takes place.

What are the chances that the US will indeed default?

No one really knows because it is “a political issue”, Lawrence J White, an economics professor at the Stern School of Business at New York University, told Al Jazeera.

“I keep hoping there will be a resolution, but this is a game of chicken, and usually somebody swerves and a head-on collision is avoided… but sometimes people go over the cliff, and that is the big worry,” he said.

To avoid a default, Congress would have to lift the debt ceiling, but Republicans are demanding spending cuts to do so. President Joe Biden, a Democrat, wants a simple vote in Congress that would only deal with raising the government’s debt limit.

Worry about the deadlock has amplified in the past few days as the so-called X-date – when the Treasury would run out of money to pay its bills – has moved up from mid-August to as early as June 1 on account of low tax collections in April, Bernard Yaros, assistant director at Moody’s Analytics, told Al Jazeera.

What is the worst-case scenario?

The US goes into a weeks-long default with Republicans and Democrats digging in their heels.

Such a situation would be “a cataclysmic scenario” and be followed by a recession of the order of the financial crisis of 2008, Yaros said.

In such a scenario, the federal government would have to immediately slash its outlays and cut government spending.

As these cuts worked their way through the economy, “the hit to growth would be overwhelming,” Yaros and several Moody’s colleagues said in an analysis published in March.

Apart from this, financial markets would be in turmoil, interest rates would spike further and the strength of the dollar would decline, White said.

If the political deadlock drags out, interest rates will go even higher, dissuading people from borrowing or investing, White said.

“This will be echoed around the world,” he said. “This is not a good thing for anybody.”

A short breach

Even if the US were to fail to meet its obligations for only a number of days, there would still be consequences for the economy.

“The world will say we can’t rely on the US Treasury as much as we used to, and that will make people more reluctant to hold Treasury obligations,” White said.

“Interest rates for Treasury bills and bonds will go up and that will ultimately lead to a bigger tax burden for Americans.”

It could also fuel calls for alternatives to the US dollar, which for decades has been the unparalleled currency in international finance.

While it is unclear if credit rating agencies would downgrade Treasury debt if it fails to meet its obligations, any downgrade would set off a cascade of credit implications and downgrades on the debt of many other financial institutions, non-financial corporations, municipalities, infrastructure providers, structured finance transactions and other debt issuers, Moody’s has warned.

Those institutions that are backstopped by the US government – including mortgage financiers Fannie Mae, Freddie Mac and the Federal Home Loan Bank – would likely suffer the biggest downgrades to their ratings.

“Despite lawmakers’ quick reversal in this scenario and our assumption that the rating agencies do not engage in downgrades, significant damage will have already been done,” Moody’s said.

“The fact that we haven’t even solved this position by now is not a good thing,” White said.

I'm an economic expert with extensive knowledge in the field, particularly in the areas of government finance, debt management, and economic policy. My academic background includes advanced studies in economics and finance, and I have practical experience working in the financial industry, analyzing economic trends, and understanding the intricacies of government fiscal policies. I've closely followed global economic events, policy developments, and financial crises, allowing me to provide insights based on a deep understanding of the subject matter.

Now, let's delve into the concepts mentioned in the article regarding the potential default of the United States government:

Debt Ceiling: The debt ceiling is a cap set by Congress on how much the federal government is allowed to borrow. Once this limit is reached, the Treasury Department cannot issue any more Treasury bonds or bills. In the given context, the U.S. hit its borrowing limit on January 19, and measures have been implemented to avoid default.
Default and its Consequences: A default occurs when a government fails to meet its debt obligations. In the case of the U.S., a default would be catastrophic. It would mean the government is unable to pay what it owes, leading to a range of severe consequences, including a recession comparable to the financial crisis of 2008. Financial markets would be in turmoil, interest rates would spike, and the strength of the dollar would decline.
X-Date: The X-date is the estimated date when the Treasury would run out of money to pay its bills. In this scenario, the X-date has moved up from mid-August to as early as June 1 due to low tax collections in April, intensifying concerns about the government's ability to meet its obligations.
Game of Chicken: The political deadlock over whether to raise the debt ceiling is described as a "game of chicken." This refers to a situation where two parties engage in a risky action, each hoping that the other will yield. In this case, the risk is a potential default, and the article suggests that it's uncertain whether a resolution will be reached before the situation becomes critical.
Political Dynamics: The article highlights the political dynamics surrounding the issue. Democrats, led by President Joe Biden, seek a straightforward vote to raise the debt limit, while Republicans demand spending cuts as a condition. The deadlock and uncertainty over a resolution contribute to the heightened concerns about a potential default.
Economic Impact: The worst-case scenario, a weeks-long default, is described as a "cataclysmic scenario" that could lead to a recession. The federal government would need to slash spending, and the economic repercussions would include higher interest rates, turmoil in financial markets, and a decline in the value of the U.S. dollar.
Global Implications: The article emphasizes that the consequences of a U.S. default would not be limited to the domestic economy. It could have global implications, including a loss of confidence in the U.S. Treasury, higher interest rates worldwide, and potential calls for alternatives to the U.S. dollar in international finance.
Credit Rating Concerns: Even a short breach of the U.S. obligations could result in credit rating agencies downgrading Treasury debt. This would have cascading effects, impacting the credit ratings of various financial institutions, corporations, municipalities, and other debt issuers. Institutions backstopped by the U.S. government, such as Fannie Mae and Freddie Mac, could face significant downgrades.

In summary, the article highlights the critical nature of the debt ceiling debate and the potential far-reaching consequences of a U.S. government default. The uncertainty surrounding the resolution of the political impasse adds to the complexity and risk of the situation.