Debt limit default would be 'a mess' for markets: Economist

Moody’s Analytics Chief Economist Mark Zandi breaks down the latest economic sentiments and concerns surrounding a possible debt limit default, while also commenting on the outlook of future Fed rate hikes.

Video Transcript

- Investors are increasingly on edge as the US gets closer and closer to being unable to pay its bills. If the US does default, it can wreak havoc on the markets and the economy. Here to tell us more is Mark Zandi, the Chief Economist at Moody's Analytics.

Mark, it's great to see you again. So we are getting closer and closer and closer to that X-date. Talk to us about one, how much is on the line here and how likely it is that you think we will see a breach.

MARK ZANDI: Well, boy, well, the probability is non-zero and it's rising. I mean, if you said to me, hey, Mark, give me a number? I'd say probably 1 in 10 at this point that we would breach.

A lot's on the line with each passing day. I suspect that if we get to the other side of Memorial Day and there's no agreement and the rhetoric is still pretty dark, I think, that's when markets will start reflecting that. If we get to the X-date and I think the X is probably June 8 not June 1, but we'll get to the date and breach.

But I think that will be very chaotic. Markets will be down. It'll be a mess.

- Has that risk elevated given what we've heard or developed over the last several days? I mean the president coming back from Japan, obviously we know he's meeting with the House Speaker today. It feels like the urgency has been upped partly because we are 10 days out, but because we just haven't seen a whole lot of promise.

MARK ZANDI: Well, in one respect, this is what you would expect to happen, I mean, because this is exactly the script that lawmakers have taken in the past. There's a lot of drama, Sturm und Drang, a lot of dark rhetoric, some signs of hope take it right down to the wire and then pass a piece of legislation increasing the debt limit. So in that regard, this feels like it's going down the same path.

But there are a lot of differences between now and other episodes that limited drama episodes mostly around our politics. I mean, our politics are much more vexed, much more divided. And of course, Speaker McCarthy is in a pretty difficult spot. He's got to come up with a piece of legislation that his caucus is going to be willing to sign on to. And that's going to be pretty tough to do.

And if he doesn't do it, he may not therefore put any kind of legislation increasing the debt limit up for a vote. And if he can't put it up for a vote, then of course, the odds of us breaching are very high. So this just feels different than other debt limit dramas and therefore more angst, and thus the high probability I attach to a breach.

- And, Mark, you broke down some different scenarios here of what we're looking at if we see a short-term breach versus a prolonged breach. When it comes to that short-term breach, what is that-- you mentioned the fact that the markets are going to start reacting. Obviously we could see a massive pullback. What does it mean for the economy, for unemployment, and why everyday Americans should care?

MARK ZANDI: Yeah, I think, we bridge. I think we go into recession. I mean, because the economy is already very fragile, most economists not me, but most economists think we're going into recession even without this debt limit drama or breach. So we're right on the precipice as it is. And then you throw this into the mix, it's going to be pretty hard, I think, for people to kind of get by this without them pulling back on their spending and investment and hiring and recession occurring.

So I think in all likelihood, if we breach for any length of time, we're going into recession. The other I'd say is it will also mean higher interest rates probably forever until we get rid of this debt limit wall altogether because investors are going to say to themselves, well, what about next time and the time after that and the time after that? If you guys were willing to breach this go around, what makes me think you're not going to do that again, and next time I might not get paid as an investor. So interest rates will be higher. So it's not only a problem in terms of the near term in recession, but it's also what it means for the longer term higher interest rates, which are corrosive on the economy.

- And Mark, there's one scenario that keeps getting thrown around by Democrats, and that is specifically invoking the 14th Amendment. I'm looking through some of your tweets to see how you view that. And it sounds like you think it's a process that makes sense but not necessarily one that we're likely to see. I mean, can you walk me through your thinking there and why that's getting pushed so much by the Democrat?

MARK ZANDI: Yeah. Well, it's kind of intoxicating, isn't it? I mean, if you do invoke the 14th Amendment and the Supreme Court upholds its constitutionality, you just gotten rid of the debt limit forever and you solve that problem. So that's why I think people kind of go back to that as a possible solution.

But it's going to be very painful, I mean, because as soon as the President invokes the 14th Amendment until the time the Supreme Court opines on it, there's going to be a very chaotic because investors are going to wonder, will the bonds issued during that period be full faith and credit? Will they be treasury bonds with no credit risk? And that's a reasonable question.

And then of course, there's the question of, well, how is the Supreme Court actually going to rule on this because you've got constitutional scholars on both sides one arguing, yeah, this Supreme Court will say it's fine and the other was saying it's not. Hard to know. I mean, you know, obviously I'm not a constitutional lawyer, but I like to play one.

I mean, my own thought is, does it make any-- can it possibly be constitutional that the government doesn't pay its bills? How can that possibly be? But the legal system and the Supreme Court may decide something different.

So a lot of uncertainty around it. So it's not-- you wouldn't want to do this unless things were really going off the rails, it didn't look like you were going to come to any agreement, you're going to be in this prolonged breach scenario with a very severe recession dead head, and then it's a Hobson's choice. What's the least bad choice here? I'll take the one with the 14th Amendment because maybe at the end of the day, we solve this problem once and for all.

- And Mark, the showdown in DC is happening at a time when the economy is already slowing. Investors really focusing on Fed policy, what we'll likely see in June. We've got recent commentary here from Powell within the last couple of days, Kashkari this morning saying that maybe it does make sense to pause, something that you've been advocating for now for quite some time. Why are you so convinced that now's the right time and we need to pause?

MARK ZANDI: Oh, well, let me name the ways. I mean, look, the economy is slowing. It's pretty clear. Inflation is moderating. And I can state with increasing confidence just given the arithmetic here, that's going to continue to moderate.

The banking system is very fragile. We're in the middle of this debt limit battle, a lot of angst around that. And I have a sense this is going to play out over a period of time. It's not going to go away quickly.

So you kind of add this all up and you say, OK, well, you know, we've raised rates from 0 to over 5% in about a year. Maybe I should just stop, take a look around, and see what kind of effect that's going to have on the economy, the banking system, and everything else. And I think what they're going to find is that they're going to get what they need. They're going to get an economy that's growing slowly, wage pressures moderating, inflation coming in coming back to target, and an economy that's sticking to the script that they want.

So I think there's a lot of reasons for them to say, hey, let's just take a pause here. And I should say, I think, Kashkari said it, it can be a pause. I mean, it doesn't mean that this is the terminal rate. If I'm wrong and inflation remains more persistent and more of a problem, they can start resuming interest rates again down the road. And I don't think any harm-- no harm, no foul at that point.

- Yeah, we heard him say the option can't be off the table, at least for another rate hike. Mark Zandi, as always, appreciate your insight today, Chief Economist for Moody's Analytics.