The US debt ceiling is making headlines yet again. Historically, after much drama, the outcome always is a raising of the debt ceiling, and things returning to normal. But this time around, things may be a little different. Well, the outcome most likely will be similar, but the interim drama can be more painful than usual.
What is the debt ceiling?
You know how you’ve got a spending limit on your credit card? Similarly, the US government too, in order to act in prudence, has a debt ceiling - the maximum amount of debt it can take.
Unfortunately, its US$ 31 trillion size, which is 1.5x the size of the economy, isn’t enough. But, Congress has the power to increase the debt ceiling if required; and it does so every time the US comes close to the limit. In fact, it has done so 78 times since 1960. It can also choose to suspend the ceiling or temporarily surpass the limit.
What’s the problem?
The government has hit the line in January 2023, and is now surviving on ‘extraordinary measures’; which may not last beyond June (yes, next month). Essentially, Congress has time till June to approve raising the debt limit. Unfortunately, there are serious differences between the parties, making Congress divided; delaying a bipartisan solution that gets passed in both the House and the Senate.
What happens if the debt ceiling isn’t raised on time?
If money runs out, and the government can’t raise any more debt, it’s left with two options:
The US defaults on its debt
There are severe reductions in state spending
Defaulting is a catastrophic event, which would put into question the credibility of the largest economy, and its AAA-rated debt. Basically, this is a financial doomsday and is likely to be avoided at all costs.
What’s likely, and has happened before is a massive drawback in spending, often leading to what’s called a partial government shutdown. Government functions close down temporarily, salaries are put on hold, government offices get suspended, and if it gets worse spending on social programmes like Medicare, unemployment insurance and defence can also start seeing cuts.
Why will it hurt more this time?
While the debt ceiling has been raised 78 times before, most of the time, the economy has been in good shape. At the moment, the US is already grappling with high inflation, and months of moves by the central bank to deliberately slow the economy down, which has now sparked fears of a recession. If the government were to see even a partial shutdown now, it could increase the probability of a recession in the US, which again has a ripple effect on the global economy.
What about the markets?
A default is a highly unlikely situation, but a partial shutdown isn’t, and global markets have already started exhibiting heightened volatility in anticipation of its negative implications. This is reflected in lower risk-reward on US equities, high-yield debt, and another round of a flight-to-safety with investors flocking to relatively stable currencies like the JPY and CHF, or the all-time favourite gold.
Until the debt ceiling is raised, or temporarily suspended, and the can is pushed further down the road, more volatility would have to be made peace with!