The Debt Limit Ought to Worry Canadians, Too

There is a lot at stake for Canadians in the faltering U.S. debt-limit negotiations.

If you have been following the U.S. debt-limit negotiations, you will undoubtedly have heard U.S. Treasury Secretary Timothy Geithner’s repeated warnings that failure to raise the debt limit would have catastrophic consequences for the U.S. economy: The credit rating of the United States would be downgraded, interest rates would rise, the safety and security of the dollar would be questioned, and the American economy would plunge back into a deep recession.

Yet, readers might be interested to learn that the effect of not raising the debt limit could have a nasty impact on the Canadian economy as well – perhaps worse than what followed the recent financial crisis. After all, the Canadian economy is inextricably linked to that of its southern neighbour, and bad economic news for the United States can spell bad news for Canada.

In light of this, Canadian Finance Minister Jim Flaherty says:

As the largest economy in the world and Canada’s largest trading partner, we are closely following the current political impasse in the U.S. … Clearly, we believe the situation needs to be addressed in the very near future to ensure continued confidence in the American and global economy.

The debt limit is a cap that Congress imposes on the amount the federal government can borrow. To be clear, raising the debt limit wouldn’t actually increase the level of debt. Rather, debt grows because of taxing and spending decisions that Congress makes separately in the budget process. Raising the debt limit simply allows the government to finance spending that Congress has already approved. Failure to raise the debt limit would make it impossible for the federal government to pay for everything it has already authorized. Furthermore, if the limit is not raised, the government will eventually be forced to default on some obligation, whether that means missed payments to government contractors, or late Social Security checks to old-age retirees.

Economists tend to agree that failing to raise the debt limit will cause U.S. interest rates to spike, as investors will demand higher yields to lend to the United States. But, if recent history is any guide, a sharp increase in U.S. interest rates would mean a commensurate increase in Canadian interest rates, as well. That could have a rather pernicious effect on the debt burdens of Canadian households that have accumulated high levels of debt over the past several years. Small business loans, mortgages, and other forms of credit would become costlier, weakening consumers’ spending power and businesses’ ability to expand and hire new employees.

Combine the effect of a sharp interest-rate hike with a slowdown in Canada’s largest trading partner, and the negative economic effect of failing to raise the debt limit grows significantly. Canadian exporters would inevitably see decreased demand from sluggish American businesses and strapped consumers, and the loss in value of the U.S. dollar would make Canadian goods more expensive.

To complicate matters even further, if the failure to raise the debt limit caused a sell-off of U.S. Treasuries, a global financial crisis could ensue. For many, Treasuries appear to be a safe-harbour asset; investors hold them because they believe such investments are secure and sellable. Thus, a large sell-off of Treasury bonds could leave institutions flat-footed. Consider what might happen to insurance companies, as well as mutual and pension funds, that together hold over a trillion dollars’ worth of Treasury bonds. If they are unable to sell their rapidly depreciating Treasury holdings, they may be unable to raise enough money to pay for insurance payouts or redemptions. It is hard to see how Canada’s financial institutions and economy could be spared in such a scenario.

To be fair, it is possible that the Canadian economy could sail through such a downturn. But, given the economic decline that Canada felt during the recent financial crisis that originated in the U.S., it doesn’t seem likely.

The unprecedented nature of this issue makes it difficult to know exactly what might happen if Congress fails to raise the debt limit, but it seems likely that the results would not be in the best interests of the American people, and that Canadians, as their neighbours, would be similarly ill-affected.

Photo courtesy of Reuters.