The American economy has been suffering from a host of issues of late, be it soaring inflation, bank failures, or a recession scare from many experts, but the most urgent matter is that clock’s hand is seriously close to a collapse on the US debt ceiling, also known as the debt limit. Up until the early 20th century, Congress needed to authorize all borrowing, however due to the US’ involvement in World War 1, a more convenient system of a debt limit was set up so that the Congress was not needed to provide permission to the Treasury for each and every debt issued. The limit is capped at $31.4 trillion today.
The technical debt ceiling was reached in January, and as of now the Treasury is exhausting “extraordinary measures” to keep the engine running, however the “reserve” tank is expected to dry up by June. What lies on the verge is a national default for the USA, itself the cornerstone of modern capital markets and the global financial system.
To understand a national default, it’s important to first understand that currently USA runs its economy on a budget deficit and has done so for every year since 1970 except between 1998 and 2001. What this means is that the government spending exceeds its revenues. Most significantly brought on by spending increases post 9/11, the 2008 recession, and most recently during the pandemic in 2020 when the deficit reached 15% of GDP at $3.13 trillion. While the deficit did ease down to about $1.375 trillion in 2022, with the government borrowing about $4 billion every day. The figure still remains massive, which has only been expected to grow to about $2.851 trillion through 2023, which would put it at 7.3% of the GDP.
Debts issued by the Treasury are thought to be virtually risk-free, which will always be paid back. They are used as the benchmark for a wide array of lending in the global economy.
How the government spends more than it earns, is by borrowing money through its marketable securities issued by the Treasury. While there are a few different kinds, for the sake of simplicity lets just refer to them under the umbrella term of bonds. Individuals and businesses might be able to “buy” these bonds, but really are just lending money, quite like a loan, and will receive payments according to a certain interest rate until the bond matures after a certain time frame, such as 10 years. When a bond matures, the lump sum principal amount is paid back. These bonds are issued by the Treasury to fund its payments, such as social security payments and to pay back interest on existing bonds. If the Treasury is unable to borrow more money to pay off its current obligations, the USA will have nationally defaulted on its debts.
Debts issued by the Treasury are thought to be virtually risk-free, which will always be paid back. They are used as the benchmark for a wide array of lending in the global economy, take for example if a government bond interest is 2%, corporate issuers will be asked to offer interest beyond the 2% on their bonds. The riskier a bond is assumed to be the more interest will be paid back. Thus, if the US government defaults, investors will deem issued debts risky and ask for a higher interest on them. A higher interest rate on the benchmark would have a trickle-down effect as credit cards, mortgages and car financing will all become more expensive. Given the systemic importance of the US economy, shockwaves will be far from contained in the US, as markets across the globe will be sent reeling.
White House economists expect a loss of over 8 million jobs, a 6.1%-point loss in GDP and the stock market getting slashed almost in half as a result of a protracted default. This is close to other expert estimates such as by Moody’s. The White House further estimates other scenarios, if only a short default is endured it might result in about 500,000 jobs lost, and 0.3% loss in GDP. However, it estimates that even if a default is avoided on the brink, it would result in 200,000 job losses.
What is likely is that despite a default, the USA will remain the core of world finance.
At the tail end, it is entirely a political situation. The Democrats hold a majority in the Senate and the Republicans in the House of Representatives. President Joe Biden and Representatives Speaker Kevin McCarthy are both ready to negotiate to avoid disaster. Republicans want steep cuts in government spending, while Biden only wants sustained cuts over a period of years in an obvious political standoff. If the steep cuts in government spending asked by Republicans do come through, according to Moody’s, a recession is likely for 2024 with 2 million jobs lost. Biden obviously also wants the ability to continue his federal spending to keep him in the running for 2024 electoral ambitions, but the question is: can he be adamant enough to risk a default and will the Republicans watch the house go up in flames with the extinguishers in hands. While the 14th amendment’s clause “validity of the public debt of the United States … shall not be questioned” could be invoked, it would but lead to a constitutional crisis, and as an expert put it “absolve the Congress from being adults.”
It is true that the Treasury could just mint a coin with a few trillion written on it and submit it into the Reserve and get rid of the problem altogether. That however is but a dirt road to massive inflation, to visit the words of Milton Friedman, “inflation is always and everywhere a monetary phenomenon,” and so such a measure is but an ugly precedent. To put it categorically, the USA is living far beyond its means. If the debt ceiling is raised yet again, only to be breached by continued deficit spending, it will be ground zero in a few years anyhow. It’s just not a sustainable situation, and sooner or later the air must burst out of the air balloon carrying the US debt. Keynesian prescriptions cannot be used as an excuse forever.
What is likely is that despite a default, the USA will remain the core of world finance. There will be a large amount of market volatility, and there is something to be said about the US political legitimacy that will suffer as a result. This comes to play when there are parties trying to advance for non-dollar-based payment systems, as well the second biggest economy in China slithering towards more and more control over the world economy. Most recently, French President Emmanuel Macron has shown a desire to depart from US foreign policy on China and maintain better relations with China given his remarks during his visit to China. The fact that at the upcoming G7 meeting in Japan, the focus of US dialogue is seen to be taking measures to reduce China’s “economic coercion” and getting a formal agreement among all seven of participant economies, highlights the reality of US fears which may begin to materialize on the reverberation of a default.
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