The United States government hit its borrowing limit last week, on January 19, leading to new economic worries at a time when most countries are expecting a slowdown in economic growth.
The US administration has already started implementing measures to avoid any default, which could have catastrophic effects on both domestic and global economies.
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Here are the nuts and bolts of the debt ceiling issue and why it matters.
What is the debt ceiling?
The debt limit, also known as the debt ceiling, is the statutory limit for the amount of money the US Treasury can borrow in the form of securities, including bills and savings bonds, to finance existing federal operations. This may include spending by the US government on social security and Medicare benefits, or paying salaries and meeting other financial obligations.
Under the US Constitution, only Congress is authorised to set the amount the US can borrow – this is done through a vote. In the last such vote in December 2021, the debt ceiling was fixed at $31.4 trillion.
US debt hit this ceiling on January 19, raising concerns among corporate leaders of a potential political standoff that could come down to the wire and unsettle markets.
The US has touched or neared the debt limits at least 20 times in the past 20 years because of a host of measures – by both parties when in power – including higher spending or tax cuts, and lower revenues during various economic crises.
Why does the debt ceiling have to be raised so often?
The debt limit has been modified 20 times since 2002, most recently in December 2021, when the previous limit was increased by $2.5 trillion to meet the rising borrowing needs and ensure the US government avoids a default.
So far, Congress has undertaken a variety of steps to deal with the situation – it has either increased the debt limit to allow for increased federal borrowing or, since 2013, temporarily suspended the debt limit seven times.
Over the years, the US federal debt has increased sharply, with 2001 the last fiscal year US government funds ran a surplus. Then the government’s gross debt stood at $5.8 trillion, accounting for about 55 percent of the country’s gross domestic product (GDP).
With the debt touching $31.4 trillion in 2023, it accounts for close to 125 percent of the GDP.
US debt has grown due to a range of tax cuts, government funding of wars along with a drop in revenues as a result of the 2007-09 financial crises and the COVID-19 pandemic – both of which led to monetary and fiscal responses, including slashing interest rates to near zero and stimulus spending to revive the economy.
This has led to a growing gap between fiscal spending and revenues. As per estimates by the Congressional Budget Office, US fiscal deficit will rise to 6.1 percent of the GDP in the 2032 financial year, compared with an estimated 4.2 percent of GDP in the 2022 financial year.
This means the government would have to borrow more to meet its spending needs. A huge part of this projected deficit will be due to the interest rates on debt, which alone would account for 3.2 percent of GDP.
What can be done if the ceiling is not raised?
On the day the US hit the debt ceiling, Treasury Secretary Janet Yellen told Congressional leaders the government has begun taking “extraordinary” cash management measures that would last until June 5, delaying the default until then.
Some of the immediate measures to reduce debt include suspending investments in the Civil Service Retirement and Disability Fund (CSRDF) and the Postal Service Retiree Health Benefits Fund (PSRHBF).
While the CSRDF provides pensions to retired and disabled federal employees, the PSRHBF provides postal service retiree health benefit payments. However, this money is not immediately required to be paid to the beneficiaries, and Yellen assured that federal retirees and employees will be unaffected by these actions.
Is Congress ready to increase the debt ceiling?
While the ruling Democrats are in control of the Senate, Republicans now have a majority in the House of Representatives and have leveraged the debt ceiling issue as a political bargain, demanding cuts on “irresponsible spending”.
“There needs to be a serious understanding that we need to rein in spending,” Republican Representative Mike Lawler told the Reuters news agency on Wednesday.
However, the Democrats led by President Joe Biden have maintained that raising the debt ceiling is “non-negotiable”.
A prolonged political deadlock on the issue would have consequences on investor and consumer sentiments, especially if the US is expected to enter a recession. A spending cut in such a scenario could spiral the economy faster into a recession.
That is already an issue of concern, with the central bank, the US Federal Reserve, sharply hiking interest rates to slow down demand to control inflation.
The impasse is reminiscent of a similar situation that arose in 2011 under President Barack Obama when Democrats and Republicans were caught in a deadlock over increasing the debt limit in Congress.
Even though a deal to raise the limit was reached just two days before the anticipated date of default, it was enough for credit rating agency S&P Global Ratings to downgrade the US credit rating for the first time in history, driving up borrowing costs by about $1.3bn in that fiscal year as per estimates by the government auditor.
The US needs an early decision on raising the debt limit since any delay would have immediate consequences.
“It is therefore critical that Congress act in a timely manner to increase or suspend the debt limit. Failure to meet the government’s obligations would cause irreparable harm to the US economy, the livelihoods of all Americans, and global financial stability,” Yellen said in a letter to Congress on January 13.
Either of those actions, she pointed out, would not authorise new spending or cost taxpayers, but would simply allow the government to finance the existing legal obligations that “the Congresses and Presidents of both the parties have made in the past”.
What happens if the debt limit is breached?
If the US government is unable to meet some of the critical expenses, such as payment to bondholders – something that has not happened to date – it would wind up in default, a scenario that would “cause irreparable harm to the US economy, the livelihood of all Americans, and global financial stability” and would “undoubtedly” cause a recession, leading to a “global financial crisis”, Yellen said in an interview with CNN on February 20.
“It would certainly undermine the role of the dollar as a reserve currency that is used in transactions all over the world. And Americans – many people would lose their jobs and certainly their borrowing costs would rise,” she added.
The majority of the world’s foreign currency reserves are held in US dollars and if the US defaults on its debt, the value of the dollar would likely strengthen against other countries, creating ripple effects in other parts of the world.