Public opinion holds the key to solving this problem, but is greatly divided

With regard to the US debt ceiling problem, the conversations between the Democratic and Republican parties have gotten nowhere, with no sign of the two sides reaching any agreement. Amid all this, the financial market has gradually been factoring in the possibility that the US may default on its debt.

The Republicans are demanding major spending cuts as a condition for allowing the debt ceiling to be raised. The House has already passed bills that would, among other things, reverse clean energy tax credits championed by the Biden Administration, recover unused COVID-19 funds issued during the pandemic, and slash spending by imposing work requirements on those receiving benefits under Medicaid (public health insurance program for people with low income). The Biden Administration, on the other hand, is demanding that the Republicans agree to raise the debt ceiling unconditionally.

Holding the key to solving this problem is public opinion. There is a growing recognition that the Republicans are to blame for heightening the risk of a default by playing politics with the debt ceiling issue and holding the economy and the financial market hostage, and if public criticism should mount, the Republicans will likely be forced to compromise ahead of next year’s presidential election.

Conversely, if the Democratic incumbents were to face growing criticism for their handling of economic policy overall, then the solution to this issue will likely require the Biden Administration to make concessions.

US public opinion is currently split in two, as if symbolizing the divisions in American society. According to a public opinion poll of 1,500 US voters taken by the Wall Street Journal (WSJ) between April 11 and 17, some 45% of voters—mainly Republicans—are opposed to raising the debt ceiling (without any spending cuts), whereas 44% (mostly Democrats) are in favor of it, and thus public opinion appears to be widely divided.

Soaring prices constitute a major difference from the last debt ceiling crisis in 2011

As happened back in 2011, whenever a congressional gridlock previously arose under a Democratic administration, and their Republican opponents opposed a debt ceiling hike, public opinion tended to become more critical of the Republicans. Yet at present, public opinion is not so clearly inclined against the Republicans’ favor. That is likely a result of the recent inflation problem.

The Republican party has leveled the criticism at the Biden Administration that the $1.9 trillion economic stimulus package which it enacted in 2021 has contributed to soaring prices. That assertion has found acceptance among some citizens, and for that reason, measures to cut spending—which include inflation countermeasures—have gained support.

Back in the summer of 2011 when the Obama Administration got entangled in a similar problem over raising the debt ceiling, the Administration ultimately was forced to partially concede to the Republicans’ spending cut proposals. Yet economic conditions are vastly different now from what they were then. At that time, the effects of the 2008 financial crisis were still prevalent, and prices were stable. The unemployment rate was in the range of 8%.

By contrast, the current supply and demand situation is much tighter, and the inflation rate is also high. For this reason, conditions are more conducive now for people to support some degree of spending cuts to curb inflationary pressures, and to have fiscal policy partly shoulder the burden of restoring price stability, which is something that economic policy has been tasked with doing.

A default would lead to economic recession and a plunge in stock prices

According to the Congressional Budget Office (CBO), if the bill regarding the federal debt ceiling being offered by the Republicans (one that would raise the debt ceiling on the condition of massive spending cuts) were to be passed, then the federal government’s discretionary spending for the fiscal year ending September 30, 2024 would be slashed by $129 billion versus what would happen under the current legislation. This would reduce the economic growth rate by 0.5%. while this move would deal a blow to the economy to some extent, if the inflation rate were to be curbed as a result, it could perhaps be acceptable to the populace.

On the other hand, if there were a technical default on US Treasuries whereby the US briefly defaulted on its debt by failing to raise the debt ceiling, then that would deal a bigger blow to the economy and the financial market.

Ratings agency Moody’s Analytics speculates that if a default were to occur, some seven million Americans—equivalent to nearly 5% of the US workforce—would lose their jobs, the unemployment rate would surpass 8%, and stock prices would drop by 20%. In this scenario, the US economy would likely fall into quite a severe recession.

Given these points, it is conceivable that in order to head off a default that would deal an incalculable blow to the economy and the financial market, similar to what was achieved in 2011, the Biden Administration might ultimately give in to some of the spending cuts that the Republicans are calling for, which also hold some promise of curbing prices.

Financial market chaos is the greatest driving force to prevent a default

Right now, public concern over the debt ceiling issue and default is not yet all that high. With the so-called X-date (on which the US government would default on its debts) approaching in early June, it is likely that the financial market will grow more volatile, at which point public awareness will be significantly elevated. This financial market disruption is in fact the greatest driving force that would lead to a resolution of the debt ceiling issue and stave off a default.

Financial market turmoil would likely intensify the public’s interest in this issue, and through surveys it would become clear which one of the Democratic and Republican parties is receiving a greater share of criticism. Given this, the political party that comes under more severe criticism will be more inclined to compromise in anticipation of next year’s presidential election, thus making it possible to avert a default in the nick of time.

A strong yen and weak stock prices would also hurt the Japanese economy

Even if “X-date” does come, the Treasury Department could put off paying expenditures like Social Security-related spending, and thereby continue making interest payments on government debt, postponing the timing of the default.

Additionally, based on the 14th Amendment to the US Constitution, which can be interpreted to mean that no limitations are to be placed on the expansion of government debt, it is also possible that the government could issue additional bonds on the grounds that any laws capping the debt are unconstitutional.

However, in the former case, the government would open itself up to a severe public backlash. In the latter scenario as well, the situation could potentially even lead to litigation over the interpretation of the Constitution. Either way, these choices would be undesirable for the government, but they might end up being employed as a means of avoiding default.

In light of these points, I would think that the chances of a default occurring are low. Yet avoiding default would carry a major cost, in that doing so would unavoidably entail financial market turmoil. Moreover, even if a default is avoided, there remains the risk that US government bonds may be downgraded as they were in 2011.

Over the next few weeks, the US will likely see a more pronounced decline in stock prices and in the value of the dollar. That would also affect Japan, potentially leading to a rapid appreciation of the yen and to dramatically lower stock prices, and dealing an even greater blow to the Japanese economy than that suffered by the US.

• Takahide Kiuchi

  Executive Economist