The US is on the brink of an impending debt default. Treasury Secretary Janet Yellen warned that if Congress fails to raise or suspend the debt ceiling, the government could not pay bills as early as 1 June.
The Republican-majority House of Representatives and the Democratic-controlled Senate have hit an impasse over the issue, with the former adamant on authorising additional borrowing only after incorporating spending cuts in the agreement. In contrast, the Democrats are demanding an increase without any conditions.
As the global superpower nears the expected date of default without any concrete solution in sight, the ramifications of a US default would be catastrophic for both Washington and the global economy.
The Debt Ceiling Mechanism
The US Congress created the debt ceiling in 1917 under the Second Liberty Bond Act during the First World War to ensure that the federal government exercised restraint in its fiscal spending.
The Debt Ceiling refers to the limit imposed on money that the US government can borrow to pay for the services it provides. The government has raised, extended, or revised the debt ceiling 78 times since 1960.
While the government has multiple revenue streams, including taxes, customs duties, etc., it spends much more than it receives, leaving it in a state of deficit which is then added to the country’s total debt annually. The Treasury may issue securities like US government bonds to borrow money, which is then paid back with interest. After the government hits the debt limit, it can no longer issue securities, thereby blocking the incoming money supply.
The US Government hit the current debt limit of 31.4 trillion dollars on 19 January, and the government has been employing extraordinary measures since then to extract additional cash to pay bills.
“If lawmakers are unable to increase or suspend the debt limit before the Treasury fails to make a payment later this summer, the resulting chaos in global financial markets will be overwhelming,” a report by Moody’s Analytics said.
State of the US Economy
Washington is already reeling under multipronged economic pressures. Inflation is at a 31-year high in the country as it still recovers from the mayhem unleashed by the COVID-19 pandemic.
The US sends billions of dollars in aid every year for its security, economic, and humanitarian interests. The Russian invasion of Ukraine had led Kyiv to acquire the top spot among countries receiving US foreign aid, with the Congress pumping 75 billion dollars in assistance to the country.
The country’s excessive defence spending is a matter of concern as it spends more on defence than the next ten countries combined, as per a SIPRI report. For instance, between January 2022 and February 2023, the US provided Ukraine more than $40 billion in military aid alone, higher than many domestic programmes. Additionally, geopolitical tensions caused by the Ukraine War have had a massive impact on the energy and food prices in the country.
Moreover, the US' standing among allies like Saudi Arabia has also taken a hit. For instance, the Saudi-led OPEC+ oil cartel has on several occasions cut oil production by millions of barrels despite the US demanding that the energy bloc raise production. A direct consequence of OPEC+'s decision has been rising gas prices in the US. A debt default when the economy is already reeling would have catastrophic consequences, both for the US and the world.
Here's a look at the potential consequences of a US debt default
Domestic Impact: A default would restrict government spending, thus barring the government from carrying out critical functions like providing social security benefits, financing defence spending, and funding the public health system. The country would witness severe social and political unrest as a default would impact overall stability.
Moody’s chief economist Mark Zandi warned that in case of a default, the unemployment rate would jump from the half-century low of 3.4 per cent at the start of this year to almost 5 per cent with a loss of nearly 7 million jobs. Zandi said, “It is fair to say that lower-income households suffer substantially more financially, as they rely heavily on the government benefits lost in the budget cuts.”
It is also possible that a debt default leads to a government shutdown, potentially pushing the US into a legal and constitutional crisis. This is also possible if the President uses the 14th Amendment to raise the debt limit without Congress. Section 4 of the Amendment says, “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”
Market Volatility and Potential Economic Recession: A default could cause significant volatility and disruption in financial markets. A financial crisis triggered by debt default is probable. It will result in the erosion of trust in the government’s ability to manage its finances. A default on treasury bonds would likely lead to a financial crisis like the 2008 recession.
The inability to repay debt would result in stock markets plunging and credit markets freezing globally. Real GDP in such a scenario is expected to fall by 4 per cent. It will lead to unprecedented fluctuations in the market with the plummeting of the bond prices and erosion of currency values.
Increased Borrowing Costs: Following a default, the government would face higher interest rates on future borrowing, increasing costs for servicing existing debt and funding government programs. Peterson Institute economists have argued that weakening official dollar purchases would likely "increase volatility in the dollar’s value against other currencies and decrease liquidity, prompting investors to reduce their holdings of dollars in any form.”
Credit Rating Downgrade: A default could potentially lead to a downgrade in the US government’s credit rating, akin to 2011, when a similar crisis was narrowly averted and led to a spike in volatility and impelled the credit agency Standard and Poor’s Global Ratings to reduce America’s AAA rating for the first time.
Weakened Global Standing: A default would also topple the reputation of the US as a reliable economic powerhouse, as much of the US' economic activity is pivoted on the understanding that it will always pay its financial obligations. A devaluation of the US dollar triggered by the default would diminish the country’s clout on the global stage and affect its diplomatic relations.
International Ramifications: A US government default could ignite an international financial crisis. “A debt default would be a cataclysmic event, with an unpredictable but probably dramatic fallout on US and global financial markets,” said Eswar Prasad, professor of trade policy at Cornell University.
US Treasuries are used as collateral in numerous transactions and are the benchmark for other debt securities, so any impact on the dollar affects the global economy.
“A default would destabilise the global financial system, which depends on the stability of the dollar as the world’s safe asset and primary reserve currency,” said Jean Ross from the nonpartisan Center for American Progress.
The impact of an erosion of the dollar’s trustworthiness would be global, as the dollar accounts for 58% of the foreign exchange reserves held by the world’s central banks. A debt default would further the push toward de-dollarisation, demands for which are already underway and will result in a shift in the global political order.
Conclusion
In the case of a default, as Zandi remarked, “No corner of the global economy will be spared.” The political callisthenics being done now need to stop urgently to prevent a 2008-like crisis from wreaking economic havoc not only in the US but across the globe. In this regard, the US must prioritise averting a default on debt payments to prevent sending the country and the global economy into a tailspin.