What is the US debt ceiling and why it is so important?

4 May 2023 , 01:17 PM

In the last few years, you would have often heard scary predictions like “The US debt ceiling may not be raised” or “US government may stop paying its bills.” Fortunately, nothing of that kind has happened till date and nothing of that kind is likely to happen in the foreseeable future. However, it is important to understand what exactly is this debt ceiling, how it is determined, how it is raised and why it matters. The debt ceiling or the debt limit reflects a cap on the total amount of money that the US government is authorized to borrow to fund government costs and meet financial obligations.

The latest debate on the US debt ceiling

In the US, the standoff between the Democrats and the Republicans (depending on who is in government) is never about the size of the debt or the increase in the debt ceiling. The big question is whether the increase in the debt ceiling should be accompanied by spending cuts or not. That is likely to be the stand-off when the Democrats and the Republicans meet in the White House on 09th May 2023. 

The fight is likely to entail a lot of hardball tactics. On the one hand, the opposition Republican party wants the increase in the borrowing limit to be accompanied by spending cuts and other cost savings. On the other hand, the Democrat president, Joe Biden, has vowed to oppose any attempt to link spending cuts to the debt ceiling. That is only likely to make the battle tougher.

What exactly is this debt ceiling?

The US government is authorized to borrow to finance expenses and meet its financial obligations. However, in the larger interests of prudence, a debt limit has been set, which is a cap on the total amount of money that the government can actually borrow. Like the Indian government runs perpetual fiscal deficits, even the US government runs perpetual budget deficits. Since it spends more than it earns, it needs to borrow to make good the gap. Considering the size of the US economy and its $25 trillion GDP, the size of the spending and borrowings would be a multiple of other countries. Some of the biggest costs for the US government include social safety net programs, interest on the national debt and salaries for members of the armed forces.

Effectively, the US debt ceiling caps the total amount that the federal government can borrow via US Treasury securities and long term bonds to meet its financial obligations. The debt ceiling was hit by the US government on 19th January 2023. Now it has reached a stage when it needs this debt ceiling revised upwards to enable the government to continue paying its bills on time. Normally, once the debt ceiling is reached, the Federal government uses “Extraordinary Measures,” a euphemism for curbing certain government investments to ensure that regular bills continue to be paid on time. 

What are the implications once debt ceiling is hit?

Normally, there are two steps here. Firstly, the government does not seek higher borrowing limits, the moment the debt ceiling is hit. It uses measures like curbing capital investments, so the routine expenses can be paid. Only once that option is exhausted, does the government seek approval for enhancement of the debt ceiling. The extraordinary measures can manage for a few months but once the cash runs out, the government needs to get a higher debt ceiling approved. In the absence of such an approval, the government cannot issue new debt to pay its bills. 

Effectively it could end up defaulting on its debt if it is unable to make required payments to its bondholders. Such a scenario is not only catastrophic for the US economy, but also for the global economy. There are other interim measures that the US government can deploy. For instance, it can prioritize payments, such as paying bondholders first. Obviously, the US government cannot be seen to default on debt. Also, the central bank (Federal Reserve) could step in to buy some of those Treasury bonds to bail out the government. 

What does raising the debt ceiling really mean?

The raising of the debt ceiling is often interpreted as a signal that the government can spend more. The raising of the debt ceiling does not authorise any fresh spending. That is something that the US Congress must authorize under the constitution. The idea of the debt limit was introduced in the 20th century, so that each time the Treasury does not have to ask for approval but they are given a blanket approval till that limit is breached. 

The debt ceiling only authorizes spending money on programs that are already approved. Hence the idea of spending cuts may not be too valid as that is not the intent of the US debt ceiling anyways. As of now, it is nearly 4 months since the debt ceiling was breached officially and since then the US government has been surviving on extraordinary measures to meet expenses.

How much debt does the United States have?

The national debt crossed $31 trillion in the year 2022. The borrowing cap is set at $31.381 trillion and that level was breached in January 2023 itself. Since then, the government has taken extraordinary measures to run the government, but that cannot run beyond June. Hence getting the approval of the house in May is important, which is why the May 09th meeting assumes significance.  In the past, the debt ceiling shift has been more of a formality since the Democrats and the Republicans face this challenge.

Remember that the debt ceiling was introduced as an ad-hoc policy measure during World War II, as a convenience measure so that the Treasury does not have to seek approval each time. If the concept of debt ceiling has lost its meaning, it is entirely likely that the same would be dispensed with. But that is not yet a major debate at this point of time. For now, the US debt is large enough to rattle the world economy, even with minor gyrations. 

What are the options on 09th May?

Broadly, there are 5 options in front of the US government when they meet on 09th May.

• The first option is that the debt ceiling is raised, as it has been done many times in the past. That has often happened in the past and it is perfectly possible that this time would be no different. 

   

• The second option is to suspend the debt ceiling, which the government has the power to do. However, this will not go down well with the global markets or rating agencies and that could roil markets.

   

• The third option is that Democrats and Republicans agree to raise the debt ceiling with some focused spending cuts. This could be a pitched battle, but it is possible. In this case, the stakes would be less economic and political.

   

• The Democrats may force an increase in the debt ceiling on the house using some archaic methods that are still offered by the constitution, but rarely used. This may raise the temperatures politically, but will still serve the purpose.

   

• The last option, and a rather intimidating one, would be if the US defaults on payments or even tries to prioritize payments. That is likely to negatively impact the global bond markets and is best avoided.

Janet Yellen summed up the situation best. “Any payment delay or prioritization would be tantamount to default since there is no provision for prioritization in the US constitution.” In short, the raising of the debt ceiling has to happen; come hell or high water.