Does the Debt Ceiling Do More Harm than Good?

This statement about the potential impact of the federal government missing payments on its debt and security obligations for several weeks, which went to the IGM’s US panel of economic experts, found a big majority in agreement that such an outcome would do substantial damage to financial markets. Some panelists elaborated on their views in short comments accompanying their answers.

Among those who strongly agreed, Darrell Duffie of Stanford (who is also a member of the finance panel) said, “Several weeks of missed payments on Treasury securities would shake confidence in the safe haven status of Treasuries, roil markets, and possibly cause market dysfunction of the sort experienced in March 2020.” His Stanford colleague Kenneth Judd added, “The US has a 200+ year commitment to pay its obligations, with the UK the only other large economy as reliable. World demand for US paper is high, reducing the cost of US borrowing. Any deviation from that could destroy its reputation.”

Among those who agreed with the statement, Bengt Holmstrom of MIT noted, “The effects are uncertain and could erode credibility unpredictably.” Larry Samuelson of Yale said, “Hints that US debt is no longer utterly safe would have far-reaching effects.” And in a remark that resonates with recent comments by Federal Reserve chair Jerome Powell, University of Chicago’s Robert Shimer stated, “The Fed has said that it would not prevent a default, but it would surely attempt to mitigate damage to the financial system. It is unclear how effective that would be.”

Among panelists who said they were uncertain, Robert Hall of Stanford declared, “I question whether it meets the standard of substantial harm.” His Stanford colleague Jonathan Levin suggested, “Seems very possible. But it would be new territory and how it unfolds could matter a lot.” And Jose Scheinkman of Columbia concluded, “The effect will surely be negative but the magnitude is very uncertain.”

The debt ceiling and risks of a global financial crisis

On the statement about the potential impact of the federal government missing payments on US Treasury security obligations for several weeks, a majority of the finance panel agreed that it would pose a substantial risk of a global financial crisis.

Many of the panelists who agreed or strongly agreed indicated how a crisis might arise from default on US government debt. Jonathan Parker of MIT explained, “A several-week ‘technical default’ by the US could lead to a significant decline in the demand for Treasury debt over years. Markets, anticipating this shift, could cause a large increase in US interest rates and crash in the dollar, which could cause a financial crisis.” His MIT colleague Andrew Lo observed, “By risking default, the US is injecting risk into the holdings of both domestic and foreign investors. Such investors will respond to this risk as all rational agents do—by holding less US debt, increasing our borrowing cost.”

Chicago Booth’s Stefan Nagel provided more detail on the link to global markets: “Given the role of Treasuries as [a] default-free benchmark in global financial markets, there is a risk of major disruptions (or, possibly, large Federal Reserve interventions to prevent disruptions).” Janice Eberly of Northwestern agreed: “A default on US government debt would disrupt the Treasury market, which underpins global markets with expected safety and liquidity. Costly recent disruptions were not as fundamental as this scenario. There is also potential longer-run impact on US cost of funds and leadership.”

Other panelists who agreed pointed to dangers to the country’s global role. Stijn Van Nieuwerburgh of Columbia argued, “If the US defaults with no quick resolution in sight, it may prove to be a turning point in which it loses its status as the global safe haven currency. What comes next is hard to predict since there is no natural alternate safe haven currency. A financial crisis may ensue.” Booth’s Amir Sufi concurred: “It would definitely be bad for the US in its role as the provider of a safe reserve currency, but the exact way in which it could cause a global financial crisis is harder to assess. The 2011 situation [discussed in this study] offers a guideline, although debt limit there wasn't hit.”

Further panelist comments explore the uncertainties around possible outcomes. Chicago Booth’s Ralph Koijen replied, “While the magnitude of the disruption will presumably depend on how long this is expected to last, there seems to be a significant risk to Treasury markets that are very central to broader financial markets.” Laura Starks of the University of Texas at Austin added, “The uncertainty surrounding the missed payments and any resultant effects will depend on a number of factors, most particularly, how investors think about the missed payments and the reputation of the safety of US Treasury obligations.”

Among finance panelists who said they were uncertain, Matteo Maggiore of Stanford remarked, “It would certainly not be a positive event, but the details would matter. It mostly would introduce an ‘incompetence risk premium’ into Treasuries by making it clear that the political system is now so dysfunctional that even the federal debt repayment can be used for bargaining.” John Campbell of Harvard commented, “Missing Treasury payments would certainly increase the risk of a financial crisis, but I think a crisis remains unlikely even in that scenario. The downside is so extreme that it is important to avoid this situation.”

John Cochrane of Stanford went further: “Delaying payments for weeks would cause problems, but not obviously a huge crisis. Regulators would quickly allow Treasuries as collateral anyway. Not good, not known, big uncertainty, but could be Y2K. That Treasury cannot issue more debt to offer bailouts might be bigger.” The one panelist who strongly disagreed, Campbell Harvey of Duke, protested: “There are plenty of actions that can be taken to reduce the risk of a default. More importantly, this would be a ‘technical’ default. The US is not in distress and it is very unlikely that a technical default would trigger a global financial crisis.”

The debt ceiling and the wider economy

On the second statement put to the economics panel—about whether the federal government missing payments on all of its obligations for several weeks would lead to substantially lower employment within six months—there is much more uncertainty in the opinions.

Among those who agreed, Larry Samuelson responded, “This one is less clear, but it is possible that the turmoil in the financial markets would spill over into significant real effects.” Bengt Holmstrom concurred, “If instability in credit markets ensue, there would be spillovers to labor markets,” while Kenneth Judd warned: “The short-run impact may be small. The major dangers are the long-term consequences.”

Chicago Booth’s Anil Kashyap (who is also a member of the finance panel) explains how default might affect the real economy: “Certainly in the first few months there would [be] a lot of damage to the economy, imagine people really not getting Social Security checks . . . There will be some recovery by six months; if interest rates are permanently higher then the damage could still be evident six months later.”

Among those who said they were uncertain, Daron Acemoglu of MIT objects: “Unlikely to see such strong employment effects in such a short time. But uncertain overall.” Robert Shimer cautioned, “This depends on how effective the Fed is at preventing damage to the financial system. Missed payments could be catastrophic, or they could have only a transitory impact on the economy.” Robert Hall disagreed with the statement, pointing to his research with Marianna Kudlyak.

The debt ceiling and the public finances

The IGM’s previous poll on the debt ceiling, conducted with the economics panel in early 2013, found broad agreement that the ceiling creates additional uncertainty and risk.

Of those who strongly agreed, Angus Deaton of Princeton said, “It does indeed provide some brake on long-term spending, but there has to be a better way.” Booth’s Kashyap added, “Deciding whether or not to pay the debts incurred to fund the previously approved tax and spending is nuts.” And his Booth colleague Richard Thaler concluded: “The debt ceiling is a dumb idea with no benefits and potentially catastrophic costs if ever used.”

Among those who agreed, Darrell Duffie noted, “This is a second chance to gridlock. A budget passed by Congress already authorizes the necessary funding.” Kenneth Judd remarked, “In the past, it was not acceptable for legislators to create the disruption from blocking a debt increase. Even RR [Ronald Reagan] disapproved.”

The only panelist to disagree in that poll was Chicago Booth’s Luigi Zingales, who argued, “It can also lead to potential better outcomes.” While he agreed with the statement, Peter J. Klenow of Stanford assented to the suggestion of potentially better outcomes: “It sure looks like it's been adding uncertainty lately (e.g. 2011). But it could conceivably be a force for good.” He added links to relevant data and arguments.