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Frozen Federal Debt Could Do Serious Damage to the Recovery

The Economy Would Suffer from the Loss of Federal Dollars

SOURCE: AP/Charles Dharapak

House Speaker John Boehner of Ohio, center, stands with other Republicans on June 1, 2011, after their meeting with President Barack Obama regarding the debt ceiling. Members of Congress, including very influential and high-ranking conservatives, are threatening not to raise the debt ceiling.

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A failure to raise the federal debt limit could be a disaster for the fragile economic recovery—and conservative threats to block action could already be causing harm.

There’s been great concern about how financial markets might react to not raising the debt ceiling, but there’s a much more direct effect that could be devastating. Freezing the debt would result in an immediate withdrawal of billions of dollars of economic activity from the economy that would rapidly affect businesses nationwide. The loss could be greater than that suffered in the worst quarter of the Great Recession. Members of Congress, including very influential and high-ranking conservatives, are threatening not to raise the debt ceiling, and the recent softness in the recovery may stem from employers and investors being reluctant to hire and invest in the face of this uncertainty.

The United States actually already hit the official debt ceiling. But the Treasury Department has been able to delay the real consequences until early August by using extraordinary measures. If Congress doesn’t act by then, however, the federal government will be forced to immediately cut nearly 40 percent from its budget. Since government consumption and investment is a major contributor to overall economic activity—contributing nearly 10 percent to gross domestic product last year—the wider economy would suffer from the magnitude and immediacy of the required cuts.

To see just how much, imagine that this debt limit crisis happened last year. The budget deficit last August and September was $125 billion. If the government had been unable to finance that deficit it would have been forced to cut $125 billion from its spending during those two months—which if translated into a decline of that magnitude in economic activity would have resulted in GDP dropping by 2.3 percent, in nominal terms, from the previous quarter.

To put that kind of drop in perspective, consider that the biggest quarter-to-quarter drop in nominal GDP since 1947, when official statistics began, was 2 percent from the third to fourth quarter of 2008—the middle of the Great Recession, when we lost nearly 2 million jobs. In other words, had the government been unable to borrow last summer, it could have resulted in an economic contraction worse than we experienced during the depths of the Great Recession. (see chart)

Five biggest quarter-to-quarter drops in nominal GDP

The impact would have been disastrous even if some portion of the forced spending cuts had come out of areas that didn’t contribute directly to GDP (transfer payments to individuals that are retained, for instance), and some of the money not borrowed by the government found its way into the economy in other ways. If only half the required cuts had reduced national income it would have still resulted in a quarter-to-quarter drop of 0.6 percent. That’s bigger than any quarterly drop during the recessions of the early 1980s, the early 1990s, or the early 2000s.

The bottom line is that even if conservative intransigence doesn’t force the United States to default on its debt, there will still be enormous economic consequences if Congress doesn’t raise the debt ceiling.

Michael Ettlinger is Vice President for Economic Policy and Michael Linden is Director of Tax and Budget Policy at American Progress.

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