Debt Playbook: Shutdown, Default, and Potential Fallout

While members of Congress and the president continue their back-and-forth over how to increase the nation’s borrowing authority, analysts are keeping a close eye on the most likely scenarios to emerge from Washington.

Here, Citigroup, the U.S.’ No. 3 biggest bank by assets outlines its best and worst case scenarios – including both balanced and non-balanced budget approaches. Still, the bank noted the damage from the fiscal fighting is likely already done to the U.S. economy – and noted the nation could see GDP fall to just 1% growth in the fourth quarter.

1. Case 1: Base Case

Citi projects a prolonged government shutdown of about one month, since the bank doesn’t foresee a deal in Washington that includes both restoring funding to the government to relieve it of its partial shutdown, and an agreement to raise the nation’s borrowing limit. Meanwhile, the bank sees a debt ceiling deal reached between Wednesday and October 31, which it says would weaken the financial system, though activity could remain constant if sentiment recovers quickly.

“Nonetheless, the base case remains at the mercy of fiscal deliberations that reflect a surprising willingness on both sides to risk serious harm. If the debt limit is not resolved before Treasury exhausts cash around end-October or November 1 at the very latest, the chances of greater negative fallout on markets and the economy would rise quickly and significantly,” Citi noted to clients.

Default remains unprecedented, and Citi notes it could cause “massive fiscal shock compounded by severe erosion in financial conditions.”

2. Case 2: Technical Default

In this scenario, the Treasury Department would run out of cash and borrowing authority as a result of no deal on a debt ceiling increase from Congress. If this happens, Citi sees a 25% decline in equity values and an increase in credit spreads that raises mortgage rates by 1 percentage point. Worse, it notes a several-hundred-billion dollar shock to the U.S. economy thanks to an immediate pullback in spending as a result of a balanced budget. Additionally, in this case, spending would slide by $220 billion. Additionally, the outcome would slow economic growth by 6.5% in the fourth quarter, and unemployment would spike to 8% in first half of the new year.

However, if this scenario plays out, the bank sees funding restored in the first quarter, a rebound on Wall Street, and no lasting shock to growth.

3. Case 3: Extended Impasse

In an extended impasse, the debt ceiling would be binding for an extended period. U.S. financial markets would not recover losses and government spending cuts would remain in place.

Citi estimates the market implication to be a more than 2% loss of growth in the new year and a full-blown recession with economic activity contracting, starting in 4Q, for three straight quarters. That would result in a 2.7% decline in GDP over one year, and an unemployment rate of 9.5% by the end of next year.

4. Case 4: Delayed CR

In this case, Congress would resolve the fiscal impasse without fiscal drag. However, the squabbling in Washington would put more prolonged pressure on market conditions – though the bank doesn’t see this as the most likely outcome, it said this situation could be a kind of foreshadowing for world-wide investors about the costs of the nation’s debt and lack of focus on fiscal framework.

5. Case 5: Balanced Budget Non-Solution

Citi said a balanced budget has the potential to overwhelm the economy and stunt recovery immediately – comparing the outcome to what would have resulted from the fiscal cliff scenario, which lawmakers managed to successfully avert at the end of 2012.

The bank said it’s nearly impossible to take a balanced budget approach to this fiscal crisis seriously because so many of the government’s dollars are allocated to programs outside of the annual budget appropriations process. Therefore, the spending cuts that would result from a balanced budget would impact discretionary spending areas that already account for just 5% of GDP. Citi notes the deficit (assuming round numbers) could approach $500 billion this year leaving spending for discretionary budgets like defense, homeland security, education, research, and social programs – below $1.2 trillion, a cut of about 40%.