US debt ceiling: What happens if debt ceiling isn’t raised?

  • 30 Jul 2023
  • Read 8 mins read

Why May 09th is critical for the US debt ceiling

There is a very important and interesting meeting coming up in the US on 09th May. The two major ruling parties in the US, the Democrats, and the Republicans, will debate about increasing the debt ceiling. Debt ceiling is a term we have heard quite often in the last few years. There have been dire predictions that the debt ceiling may not be raised. That means; US government will not be able to borrow and pay its bills on time. Fortunately, nothing of that kind has happened, but this debate on May 09th is a lot more significant.  The real issue in the debate is not the size of the debt or increasing the debt ceiling. It is about linking an enhancement in the debt ceiling to spending cuts. The ruling Democrats want unconditional raising of debt ceiling while the Republicans want any debate on debt ceiling to be accompanied with spending cuts. Joe Biden has made it his own personal battle.

 

First, a word on the debt ceiling

Debt ceiling was introduced during World War I and came into its current form during World War II. In the past, the Treasury had to seek approval for each borrowing. Since that was not feasible during the war, the government devised a debt ceiling as the limit up to which the US government can borrow. Currently, the debt ceiling limit stands at $31.38 and this ceiling had been breached in January 2023. Over the last 4 months, the US government was meeting its commitments through cuts in investments. However, that is unlikely to last beyond June 2023. That is why the approval has to be sought in May itself. Remember, that the US economy has an annual GDP of nearly $25 trillion so the debt obligation of $31 trillion is not too alarming. The debt ceiling caps what the Federal government can borrow through short term and long term treasuries. 

Will raising debt spending lead to a spending spree?

One argument against raising the debt ceiling is that it could lead to rampant spending. However, that is not entirely true. Raising of debt ceiling is not the same as authorising fresh spending. That is something the US Congress must still authorize. In fact, what the debt ceiling does authorise is to spend money on programs that are already approved. Also, there have been multiple occasions in the past when the Federal government had to raise the debt ceiling. Despite heated debates, the debt ceiling enhancement has normally gone through.  In the last 20 years the US government spent heavily on wars in Afghanistan and Iraq as well as on COVID measures. All these factors led to a spurt in the debt levels.

Six things that can happen on the debt ceiling front

When the US Congress meets on 09th May to decide on the enhancement of the debt ceiling, there are several possibilities.

  • Firstly, it is perfectly possible, that as in the past, the raising of the debt ceiling gets approved smoothly. That has been the case in the past and it is unlikely to be any different this time. In that case, it would be business as usual, although the US would still have to worry about the levels of debt in the economy.

     
  • The second option is not oft discussed as it is seen as too aggressive. Technically, the debt ceiling can be suspended, in which case the Federal government gets a virtual free hand to borrow. However, this may not go down too well with the markets or with the rating agencies. Investors still prefer Federal governments to be conservative about debt. The total suspension of the debt ceiling is very unlikely.

     
  • Thirdly, there could be a consensus between the Republicans and the Democrats to meet halfway. Ideally, the Democrats may agree to some spending cuts but they would not want to be seen as entirely pro-business. So anti-populist spending cuts would be avoided. In this case, it would be politically prudent as both parties can claim victory and the debt ceiling gets raised and it is business as usual.

     
  • Fourthly, there are some very archaic provisions in the Constitution that still allow the ruling party to force such decisions. While these provisions do exist in the Constitution, they are rarely used in practice. While using such provisions would be legitimate, it may not go down too well with the American people with elections coming up next year. 

     
  • The fifth option is to prioritize some of the payments. For instance, the government can pay debt on time but hold back other expenses. However, the Treasury Secretary, Janet Yellen has an interesting take on this prioritization. According to Yellen, “Any payment delay or prioritization would be tantamount to default since there is no provision for prioritization in the US constitution.” That almost makes the raising of the debt ceiling inevitable.

     
  • Finally, there is the sixth, and perhaps, the most intimidating option. If nothing works out, then the US Federal government could default on its obligations. That would not be an encouraging decision by the world’s largest economy. That is likely to have an adverse impact on the global bond markets, including bouts of volatility. 

In the past, debt ceiling hikes have got approved easily. The difference, this time around is that both parties are sticking to their knitting. Eventually, the ceiling hike should get through, without too many hassles.

Content Source: CNBC.COM