Yahoo Finance What’s the ‘Debt Ceiling’? And how could it impact Australia?
The deadline is fast approaching. At 12:01am Friday the ‘debt ceiling’ in the United States will need to be raised and if not the US Government will be shut down.
The event has been flagged by US Treasury Secretary Janet Yellen as potentially “catastrophic” and US Federal Reserve chair Jereome Powell warned it could cause “severe damage”.
So, what is the ‘debt ceiling’, what are the ramifications if it is not raised and how will it impact us in Australia?
Here is a breakdown.
What is the debt ceiling?
It is essentially what the name implies - the debt ceiling is the limit of debt the US Government can have at any given time.
It was introduced by Congress in 1917 to give both Houses of Government oversight on spending and borrowing.
This means that should the debt ceiling need to be raised, both houses need to agree to raise the ceiling to pay off the existing debt.
Currently, US Government debt sits at $39.2 trillion (US$28.43 trillion), according to the Peter G. Peterson Foundation’s live tracker.
That is $118,615.31 (US$86,024) of debt for every person in the United States.
And, while the deadline is Friday, the limit was actually hit in early August this year - so the US Treasury has been using its cash balances since then to keep the Government running.
But, they are estimated to run out sometime between mid October and mid November.
Why not just raise the ceiling?
Well, as with many things in the United States - it all comes down to politics.
John Noonan, regional director for Forex Watch in Asia for Thomson Reuters told Yahoo Finance that raising the debt ceiling is not unusual, but the political games are a new development.
“They have raised the debt ceiling over 70 times in the past, but over the past 25 years it has become a political football when there hasn’t been a clear majority of Senate and House seats held by the political party occupying the White House,” he said.
“Political brinkmanship in 2011 when Barack Obama was President is the closest the US came to defaulting on its debt. At that time the Republicans controlled the House of Representatives where the so-called ‘Tea Party’ contingent dug in their heels.”
What will happen if the ceiling isn't raised?
Well, as Yellen said it could be “catastrophic”.
Shane Oliver, chief economist at AMP Capital explained to Yahoo Finance that the US Government would be left unable to fulfil its obligations.
“If the debt ceiling is not raised the US Government could default on some of its required payments,” Oliver said.
“It would have to cut spending to be in line with tax revenue which would mean about a 12 per cent of GDP reduction in spending.”
12 per cent of US GDP in spending is around $3.54 trillion (US$2.57 trillion) - so the Government would have to try and find that money by making massive cuts.
Not only that, but the Government also wouldn’t be able to pay interest on holders of Government bonds or things like social security payments.
“The idea that the United States would default on its debt commitments is almost unthinkable, and it would severely damage the reputation of the United States, the role of US Treasuries as the ultimate safe-haven protection and the US dollar as the world’s reserve currency,” Noonan said.
“Global markets would go into turmoil, but the extent of the damage would be determined by how long debt payments would be suspended and the measures taken to ensure it never happens again.”
So, why on earth would US politicians even be holding out on increasing the ceiling? As Noonan said, the situation comes down to politics again.
“From a political point of view, it would damage the Biden White House and its projection as being far more stable than the tumultuous four years of the Trump administration,” Noonan said.
“That is why the Republicans in the Senate are holding out as long as they can.”
What are the solutions?
In 2011, when the US was going through its last debt ceiling crisis, the idea of minting a $1 trillion coin was floated.
Essentially, to bypass the need to raise the debt ceiling, the US would create a very high value platinum coin.
But what about inflation you say? Well the way it works in the US is that while paper currency is subject to accounting and quantity restrictions, platinum coinage is not.
The idea for the trillion dollar coin was rejected by the Treasury and the Federal Reserve in 2013, but has once again surfaced.
And while the idea is an interesting one, the experts agree that it isn’t a likely solution.
“I don’t think it would be a credible solution – even if it technically solved the problem in the immediate-term,” Noonan said.
“The Fed operates separately from the US Government so it simply won’t agree to directly finance Government operations by printing money in any form. Anyway, no one could afford to buy such a coin,” Oliver said.
(Side note: Currently (and thankfully) there are no trillionaires in the world yet. Here’s who is on track to become the world’s first trillionaire).
But, there are still other options if the politicians can’t agree.
The Democrats can pass a “budget reconciliation bill” that would only require a simple majority, but they don’t want to do that, Noonan said.
“Much of the debt owed was incurred during the Trump administration,” he said.
“They don’t want to do it as it will jeopardise their efforts to pass a US$3.5 trillion fiscal package that is the centre-piece of the Democrat promise of infrastructure building.”
The most likely solution, Oliver said, is that the Democrats will agree to reduce the size of their spending package which gets enough people on side.
“It may take a while to reach agreement to get to this point though. But it's ultimately the way it will go I think,” Oliver said.
How would a US default impact Australia?
If the US were to default it would send global markets “reeling with extreme volatility”, Noonan said.
“It would also impact global growth prospects, as it could result in a credit crunch similar to what we saw in the 2008/2009 GFC,” he said.
“I feel that it is highly unlikely we will see a technical US default and action will be taken to avoid such a calamity. But, if the brinkmanship in the lead up to a solution drags on, it could be a catalyst for a market correction lower, as markets are already looking a bit fragile.”
Oliver agreed that it is unlikely the Government will allow such a thing to happen, but even the current process of getting an agreement could cause volatility on the US share market.
“If the debt ceiling is not increased and US government spending has to be slashed to be in line with taxation revenue then it could knock the US into recession which would be bad for global growth and may threaten Australia’s post lock down recovery,” he said.
If the US were to be plunged into a recession at this stage in the global recovery, economies around the world would be impacted.
Share markets would crash, huge amounts of money would be lost, and with Governments already in large amounts of debt as a result of COVID-19 it is easy to see why warnings have been made.
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