What is the US debt ceiling and why does it matter

The debt ceiling is a national-level cap on Federal borrowings. In the case of individuals, the limit is decided by income levels, asset value, existing debt etc.

October 01, 2021 8:51 IST | India Infoline News Service
Over the last few weeks, Treasury Secretary Janet Yellen has been consistently warning that if hike in the debt ceiling was not approved, the government would run out of cash by mid-October. That is not too far away. It is hard to imagine the US government unable to pay for social security, medical aid, armed forces and salaries of department employees. But, theoretically, that is what could happen if the debt ceiling is not raised. Let us understand what this debt ceiling is all about.

What exactly is this debt ceiling in the US

The debt ceiling is a national-level cap on Federal borrowings. In the case of individuals, the limit is decided by income levels, asset value, existing debt etc. However, in the case of governments, the story is slightly different since they can also print currency. Hence, the only way to instil some fiscal discipline in governments is to put a debt ceiling. The US government, like most governments elsewhere, is authorized to borrow to fulfil its financial obligations. In the case of the US, it has always run budget deficits, so it had to borrow to meet basic commitments. Debt ceiling is about how much they should borrow?

Chart Source: US Treasury

What does the US government do when it approaches the debt ceiling. The current level of debt ceiling is $22 trillion. Once it reaches that debt ceiling, there are two choices. It can get the approval of both houses to hike the debt ceiling. The other option is to just suspend the debt ceiling as has been done now. Currently, the total debt is $28.43 trillion against the stipulated debt ceiling of $22 trillion. Since the first World War, the debt ceiling has been hiked or suspended 78 times. So, what is the sanctity of this debt ceiling?

There is a subtle sanctity to the US debt ceiling

Even though the debt ceiling has been shifted time and again, the government does not stop spending once the debt ceiling is reached. It only limits itself to authorizing the financing of obligations. No new spending or investments can be taken up when the debt ceiling is breached.

The sanctity of the debt ceiling was first highlighted by Newt Gingrich in 1994, where he underscored that both Democrat and Republican governments must respect the debt ceiling a lot more. Currently, the US government has been curtailing its fiscal investment outlay to be able to pay the bills on time.

The US government has never defaulted and there is no way they would want to default on their obligations as it would mean a sharp fall in the value of the dollar and a global payment crisis. That would throw the entire dollar hegemony in disarray and the US government would not want to risk such a situation. Hence, if the debt ceiling cannot be raised, it will have to be managed.

The US debt is already at $28.43 trillion, which his roughly 36% more than the US GDP. Also, the current debt ceiling is $22 trillion and the demand is to hike it to $28.4 trillion. However, even at that level, the leeway is limited for the US government.

Is it necessary to have a debt ceiling at all?

Not all countries have a debt ceiling, except a few prominent countries like the US, Denmark and Poland. India has a debt ceiling in the form of FRBM Act, but that has also been stretched in the last 2 years. The debt ceiling is more of a legacy issue, which nobody wants to disturb. For example, the first debt limit came via the Second Liberty Bond Act of 1917 and an overall general limit on the federal debt was imposed in 1939 at the start of WW-2.

However, now that the debt ceiling exists, it is more a question of who will bell the cat. Neither the democrats, nor the Republicans want to be seen as patently extravagant in their functioning. This is likely to be met with public resistance. Therefore, scrapping the debt ceiling is a delicate issue and neither Democrats nor Republicans are open to that idea.

One options is to invoke the 14th Amendment wherein the debt ceiling becomes redundant. However, this 14th amendment is only workable in the midst of an emergency and not on a regular basis.

Avoiding a repeat of the 2011 crisis

Back in the year 2011, the US came pretty close to default on its debt. This had resulted in the S&P 500 index tanking by over 18%. But it also brought child tax credits, food stamps and social security to a standstill. This would deeply impact the scores of businesses that rely on the government for orders.

Any default in the debt ceiling would have an impact on almost each and every market as the traditional safe haven of the US would not be available any longer for the flight to safety. It is this debt ceiling that gives the exorbitant privilege to the US Dollar.

FREE Benefits Worth 5,000



Open Demat Account

  • 0

    Per Order for ETF & Mutual Funds Brokerage

  • 20

    Per Order for Delivery, Intraday, F&O, Currency & Commodity