Debt Ceiling: How Political Uncertainty Hurts US International Credibility & Financial Stability

Although the Senate Republicans have agreed to approve the government funding they are still up in arms about raising the debt ceiling. Does this mean that a technical default is imminent? Professor Thomas Prusa and former Treasury official Gary Hufbauer have discussed the potential consequences of the latest partisan standoff.

Senate Democrats reached a deal with their Republican counterparts on a stopgap bill on Wednesday night to avert a looming shutdown, as the government funding is set to expire on 30 September. However, the measure does not include the suspension of the debt limit. Previously, the Dems tried to pair the two issues but faced opposition from Senate GOP that blocked the stopgap legislation on Monday.

If the debt ceiling is not raised the United States might be dragged into a crushing default, Treasury Secretary Janet Yellen warned in her Wall Street Journal op-ed earlier this month. Following the GOP's rejection to suspend the debt limit, Senate Majority Leader Chuck Schumer signalled that Democrats were making every effort to avoid a default, complaining that "Republicans have stymied [them] at every opportunity."

What are Possible Consequences of Default?

"If [default] were to occur, even the threat or possibility of that is very damaging to the US economy and it’s likely interest rates will go up – even a one percentage point increase in required interest rates due to this uncertainty would be extremely costly," says Thomas Prusa, professor of economics at Rutgers University.

Similarly, the default's consequences on the international economy would be dire in both short and long run because it would create chaos in debt markets, according to the professor.

"It will be a real shock because the first thing that will happen is the market will drop, and that's a big part of the financial market," says Gary Hufbauer, a former US Treasury official and non-resident senior fellow at the Peterson Institute for International Economics. "You know, easily that they could drop 5 percent, even 10 percent, because this is a real shock to the financial system. And then if that happens, companies will shut down. They will not increase employment, which they are doing now, they will instead decrease employment."

Secretary Yellen warned that a default would be disastrous for millions of families and workers.

Senate Republicans have solidified themselves as the party of default.

We are working to raise the debt ceiling and avoid irreparable economic harm to people and families.

— Chuck Schumer (@SenSchumer) September 29, 2021

To make matters worse, it could substantially undermine the US international credibility, according to the former Treasury official. For decades the US has remained "a financial rock of Gibraltar," however, the political standoff in the US Congress could now give the shivers to "all these foreign central banks which hold Treasury bonds and all the share markets which are responding to the price of Treasury bonds," Hufbauer suggests.

In addition, a potential default would inevitably backfire on President Joe Biden, if it happened on his watch, according to him.

U.S. Senate Majority Leader Chuck Schumer (D-NY) talks to reporters as he heads to the Senate floor in Washington, U.S., May 17, 2021.

© REUTERS / EVELYN HOCKSTEIN

Partisan Battle at Core of Problem

"The main reason it's evolving is because of the political contest between the Republicans and the Democrats," Hufbauer suggests. "And the Republicans want the Democrats to take all the blame for issuing more Treasury bonds and possibly having more inflation in the United States, which is very unpopular."

Hufbauer suggests that "the Republicans think that let's let the Democrats bear the blame, and that will increase the chances that we will win in November 2022."

"So, that's it, it's a political battle between the two parties with a view to the congressional elections in November 2022, which will decide which party controls the House of Representatives and the Senate," he says.

The United States is approaching $30 trillion in debt.

That’s nearly $90,000 of debt for every American citizen.

Today, my opponent Adam Kinzinger voted to put America further into debt by raising the debt ceiling to fund the Democrats’ socialist agenda.

— Catalina Lauf (@CatalinaLauf) September 29, 2021

The GOP justifies its demarche by referring to the Dems' "spending spree." While refusing to raise the debt ceiling the Republicans argue that the Dems' policies have already escalated inflation and added to the already bloated national debt, which now stands at $28.8 trillion. At the same time, the Republicans are concerned about the fact that the Dems-backed $3.5 trillion spending plan will be accompanied with substantial tax hikes which could endanger the US post-COVID recovery and hit not only "the rich" and corporations but all social strata.

U.S. Senate Minority Leader Mitch McConnell (R-KY) reacts as he speaks to reporters following the weekly Senate lunch at the U.S. Capitol in Washington, D.C., U.S., September 21, 2021. REUTERS/Elizabeth Frantz

© REUTERS / Elizabeth Frantz

Default is Unlikely, But Uncertainty Fraught With Risks

The silver lining in this situation is that the probability of the default is not high, according to the economic experts.

If the debt ceiling doesn't get passed this week, it will get passed within the next couple of weeks, believes Prusa. Nevertheless, the unfolding situation caused by the partisan brinkmanship "does create uncertainty in international markets," he notes, adding that it's "expensive not just for the United States, but especially for emerging markets, because markets will continue to look even riskier than the United States."

"More than nine chances out of ten or even 95 out of 100 – it will be avoided," echoes Gary Hufbauer. "And the way it will be avoided is that the US Senate will vote to extend the debt limit, to raise the debt limit or just to suspend it, not have any debt limit and do it with a measure that only requires 50 senators and it's half of the senators, to vote in favour. Plus, the vice president, Vice President Harris, who's the president of the Senate under the US Constitution. So that gives them the vote. And the Democrats have that power. They can do that."

However, the Dems don't want to use this power right now, "because they want the Republicans to also vote to increase the debt limit, and that's the standoff between the two parties," the former Treasury official emphasises.

Moreover, it appears that the partisan battle is only gaining pace: "What's likely is the current agreement will likely set the debt ceiling only to get us to December," forecasts Prusa. "We're likely going to have the same issue in about two and a half months and then several more times now in the campaign, because they're not setting the debt ceiling at significantly higher than it is in this scenario. This discussion is going to continue to play out."

This political contest will reverberate through global markets, given the importance of the US economy and the US debt market internationally, the professor believes.