How Bad Could A Government Default Get?

With less than a week until the U.S. runs out of cash, economists and policymakers are using words like “cataclysmic event” and “calamity” to describe what will happen if Congress doesn’t raise the debt limit. 

It seems bad. Economists are predicting that if the government is unable to pay its bills, it could bring much of the global financial system to a halt. But everyday people will be affected too. So who would a failure to raise the debt limit hurt first — and who would be hurt the most?

You can think of the impact of the default as a sinkhole, pulling down the people closest to the epicenter first but spreading out to more and more people until (depending on how long it lasts) it finally engulfs the U.S. economy. The first people who are likely to be affected are those who get money directly from the government, including government employees and recipients of government direct payments, like retirees, veterans and disabled Americans who rely on social security income. Soon, though, the government’s inability to pay its bills might hit health care providers who are reimbursed through Medicare and Medicaid. Homebuyers, too, could get hit by higher interest rates, making it even more difficult for them to purchase houses in an already-competitive market. All of this adds up to a potential economic slowdown that could cause a severe recession if the crisis drags on.

People and organizations who get paid by the government

The looming crisis is simple: If the Treasury were to hit the debt limit, it would no longer be able to borrow money — even to make good on debts Congress has already incurred. That means it wouldn’t bring in enough money to meet all of its obligations, forcing the government to make decisions about where available cash should go. If a default happens, the government is likely to prioritize monthly Treasury interest payments that preserve its ability to borrow in the future and minimize chaos in the financial markets, according to a Moody’s Analytics report published earlier this month. When making tradeoffs about which of its financial obligations to fulfill, direct payments to people and institutions who rely on government money could be affected. (An additional complication is that prioritizing some payments over others may not be legal, so the government could face a raft of lawsuits.) 

A lot of people rely on the government to pay its bills on time. There are almost 2 million federal government employees whose direct income could be affected. That doesn’t include the roughly 1.3 million active-duty military personnel, as of last count, and an additional 3.9 million veterans who receive disability support. The government could furlough or lay off workers in an effort to save money during a debt-ceiling crisis, leaving many of these people without an income. These tradeoffs could start to happen immediately, since one of the first bills that’s coming due is $12 billion in promised veterans’ benefits on June 1, and an additional $5 billion in federal salaries and insurance is scheduled to be paid out on June 9, according to an analysis by the Bipartisan Policy Center.

Additionally, just about 66 million Americans received some form of social security benefit, like retirement or disability income, as of the end of 2022. That number included 7.6 million disabled workers who receive Social Security Disability Insurance. Federal policy already limits the ability of recipients to save, because of asset limits, and the amount of additional income allowed, so going without any one check could pose a severe hardship, said Kimberly Knackstedt, director of the Disability Economic Justice Team at the left-leaning The Century Foundation. “That sort of insecurity of, ‘Is this check that’s already not enough to get housing and food going to come this month, or is it not,’ is causing serious concern for us and for people around the country,” Knackstedt said.

Almost 6 million people are receiving unemployment payments, too. While unemployment insurance is administered by the states, it relies on federal money that could also be disrupted, according to Bernard Yaros, an economist at Moody’s Analytics who focuses on federal fiscal policy. The government has multiple Social Security payments set throughout the month of June, according to the BPC analysis, which could be delayed.

And it’s not just individuals who rely on government payments. Industries that contract with the federal government, like the aerospace industry and defense contractors, are vulnerable, according to Moody’s. Health care institutions could also suffer, especially small and rural hospitals, because they rely on Medicaid and Medicare payments for much of their revenue. States heavily reliant on these industries, like Virginia, could see hits to their local economy that might be bigger than the impact on the country as a whole. 

Homebuyers

Homebuyers would also be hard hit. The housing market, walloped by dramatic ups and downs during the COVID-19 pandemic, is just reaching a tenuous stability. Mortgage interest rates remain high, which has kept some buyers out of the market, but there are just enough buyers and sellers to see some activity. That could all change with a crash, which is what might happen if large numbers of people are suddenly pushed out of the market by higher rates. Jeff Tucker, a senior economist at the real-estate marketplace Zillow, estimated that rates could go up by an additional 2 percentage points. If that happened, he said, “the housing market would get pushed down further 23 percent from … the pace we were expecting for this summer.”

Moreover, homebuying remains an important wealth-building tool, and it’s already been a market where those looking for affordable options have struggled to gain a foothold. A longer default could mean that rates remain high for a while, making it even more difficult for non-wealthy people to buy. “I think the longer term impact there will be to widen inequality from a wealth-building perspective,” Tucker said. White adults are already much more likely to be able to afford a home, and the median age of first-time homebuyers is rising. A debt default crisis would make that problem worse just as a diverse generation of millennials enters prime home-buying years, he said.

The entire economy

Then there’s the threat to the broader economy, which isn’t as direct, but is still very serious. Think about it this way: In addition to the tumult that’s likely to ensue in the financial markets, if all of the people who rely on the government for payments are suddenly struggling, then those effects will ripple out to the economy, because they and the other recipients of government payments won’t be buying goods and services to the same degree. That’s part of the reason economists warn that a debt default could create a recession, even if the crisis is short. A prolonged crisis could have severe consequences, especially because the economy is already fragile. 

Moody’s calculated the result of a short debt-ceiling breach as a 0.7 percent decline in real GDP, 1.5 million jobs lost and an unemployment rate that nears 5 percent. But a debt-ceiling breach that lasts through July would cause “economic carnage.” The Moody’s report forecasts real GDP would fall by 4.6 percent in the second half of this year, and an unemployment rate that rises to 8 percent. The downturn could have lasting effects in the form of higher interest rates and reduced growth throughout the next decade.

In all, though, the financial credibility of the American government itself could be seriously harmed — which could have long-term economic impacts on ordinary people too. In 2011, a similar debt-ceiling fight led S&P to downgrade the U.S.’s credit rating, and something like that could happen again, costing taxpayers money. (Indeed, Fitch, a major credit-rating agency, has already issued a warning.) Once it defaults on its debts, even for a short while, a message about the faith the world can have in the U.S.’s political and financial systems will already have been sent. “You would be forgiven if you looked at all the data right now and said, ‘Oh, the consumer is resilient. The economy is resilient. We can, it can withstand this brinksmanship,’” Yaros said. But inflation is still high, and risk of a recession is just under the surface, which means the economy could already be headed toward a downturn in the year to come. “The debt limit would just accelerate that, or it would just pour kerosene on,” he said.