Can the US default on debt; and what happens if they do?

24 May 2023 , 09:59 AM

The big question in the minds of the global markets today is whether the US government would actually default on 01^st June. The US has already hit the debt ceiling of $34.1 trillion in January 2023 and since then it has been operating on emergency measures. That is likely to extend only till the end of May. Unless a decision to either enhance the debt ceiling or to scrap the debt ceiling is taken before that, the US could technically default on its bills. That may sound strange to hear, but it is perfectly possible on paper. Let us look at where the US government stands on the debt ceiling, is there enough time, what are the options, and what could be the worst case impact on the global financial markets?

Where do we currently stand on the Debt Ceiling talks?

As of today, the US President Joe Biden and Kevin McCarthy of the Republican Party have been having hectic parleys to hammer out a solution. While the talks have been productive on paper, there is still no debt deal. The wordings are positive but cautious. McCarthy has said that a deal was perfectly possible while Biden assured the world that any default was out of question. However, the reality may not be as discrete and simple as that.

If the debt ceiling is not raised beyond $31.4 trillion by 01st June 2023, there is likely to be a default. At that point, the US government will not be able to borrow any further. For now, the Republicans and the Democrats are in sync that the debt ceiling needs to be enhanced. However, Republicans are demanding $4 trillion in spending cuts and Democrats have, at best, agreed to keep spending flat. That is the bone of contention and the problem is that the Democrats do not have a strong enough majority to push their way in both houses.

The sense of urgency cannot be missed for now. Biden has already cautioned that it will take at least 72 hours for the deal to be written, read, and voted on. On the other hand, Treasury Secretary, Janet Yellen, has warned that in the absence of a debt deal, there would be a default, with its numerous ramifications. Biden and McCarthy are under pressure from their respective parties to hold their line. With just a 1-seat majority for Democrats in the Senate and Republicans in narrow control of the House, the deal may tough and elusive.

Bottom line: the debt ceiling deal will take time

With time running out, one thing that the likes of Biden and Janet Yellen have been warning about is the time needed to fructify such a deal. It is already just 8 days to 01st June, and the situation may be “touch and go”. Here is why. 

Any debt ceiling agreement will have to pass through Congress and that looks tough with just 8 full days for the deadline. The US Senate is currently out of session while the House of Representatives has a planned recess for Memorial Day on 29th May. Just getting enough legislators in town to vote would be a logistical challenge, since only 6 of these days are working days. A smooth raising of debt limit would take anywhere between 7-9 days. Members would typically require about 72 house to review the text of the deal, so the deal has to come through by Friday 26th May. 

The Senate has to approve the legislation, and even one recalcitrant legislator can delay the vote for days. Only after full Congress approval, the technical details will be drafted for the presidential assent. But analysts are confident that the US may just about pull through. It just needs to manage till 15th June, as the tax collections will start flowing in by then, allowing the government to stretch the deadline to July or August. However, the US will still need about $300 billion to make it that far and Yellen has already ruled out prioritization of debt, calling it default by another name.

Will the US government actually run out of funds?

The US government is very likely to run out of money within weeks unless it allows itself to borrow more. The debt ceiling matters because it limits the total amount of money the government can borrow to pay for federal employees, military, social security, and Medicare; apart from interest on national debt and tax refunds. Normally, raising the debt ceiling is a formality, but this time around the close seat share of the Republicans and Democrats has complicated the process. So, technically, the US government could default.

Janet Yellen has already warned that without more borrowings, the US does not have enough money to meet all financial obligations by the 01st of June. Nobody knows what will happen if the debt ceiling is not raised, since such an eventuality has never arisen before. But, it would mean that the government would not be able to pay salaries of federal and military employees as well as social security cheques, that scores of US pensioners rely on. Much of US funding support globally would dry up. In 1979, the US government had entered default due to an accidental default, but this time around it could be an intentional default.

Is there a more drastic solution? In the absence of a deal, the Congress can invoke 14th amendment of the Constitution, which states that the ‘Validity of the public debt of the United States shall not be questioned’. While that is an option available to Biden, it could be controversial and could even spark off a legal battle. The most likely solution is a short-term extension to give Congress more time to strike a deal. But delays have a cost as we saw in the brief US credit rating downgrade in 2011. 

 

What is at the heart of the debt ceiling deal?

Let us understand what is at the heart of the debt ceiling deal and why the Republicans and democrats are so divided about it. Here are some key points.

• Republicans want to cap government spending for future federal budgets, but the Democrats are only willing to accept short-term limits, by possibly freezing 2024 spending at 2023 levels. Republicans want $100 billion of spending cuts next year.

   

• Republicans want people receiving food stamps, financial aid, and Medicaid to be actively seeking work or enrolled in an education programme. Democrats are not ready as the Medicaid program has been one of their key themes.

   

• There are also differences over unspent COVID funds and energy permits. Republicans want the COVID funds to be returned to the government as the pandemic has allayed. Republicans also want easier permits to oil companies for energy development projects. The Democrats disagree on both fronts.

These differences are currently holding up the deal and as of now neither parties look too keen to reach a compromise formula.

Finally, can a default unleash chaos in global markets?

A US default means chaos! If the Democrats and Republicans do not agree to allow the US to borrow more (debt ceiling deal), the US could default on its $31.4 trillion debt. Here are some of the likely implications of a default.

• The chances of a default still look remote, but if it happens then the US economy could visibly slow down. Some even say it could make the global financial crisis of 2008 look like an innocuous tea party. In fact, leading economist, Mohamed El-Erian, expects a default to even tip the US into recession.

   

• A US default is likely to raise US mortgage rates, making mortgages costlier across the world. Inflation could spike even as the economy slows and the repercussions could be felt globally. If the US can default, the fear is that no country in the world is immune from defaulting. That is not a good feeling and bond yields could shoot up.

   

• Dollar chaos could be a much bigger issue. Today, almost everything from Brent Crude to spot gold to base metals are priced in dollars. If the dollar gets wobbly, pricing these commodities could become difficult. 

   

• The US government bonds are the most invested bonds in the world and a default would lead to a sharp drop in the value of these bonds. So, the entire world is suddenly going to become a lot poorer if the US defaults.

To sum it up, the consequences of a default could be felt globally. The best hope now is that the deal happens and everything heads towards a happy ending.