Debt Ceiling Fight Could Sink The Economy!!

The impart of Debt Ceiling on the US economy have been discussed in our previous articles “Debit Ceiling – An Explainer (Part I)” and “Debit Ceiling – An Explainer (Part II)” and therefore in this article we are going to see how a debt ceiling could sink the economy. So let’s get started.

Introduction on Debt Ceiling

On 12th February, 2023, on this website, we wrote an article titled “How Much Debt Is Too Much? …” We’re back to talk about the debt ceiling now that President Biden and Republicans in Congress are fighting over it. As already interest rate hikes are taking a toll on the banking system the consequence of a default would be disastrous and can be a big blow to the financial markets. The battle over the debt ceiling intensifies as there more economic problems arise.

The debt limit was increased from $ 2.5 trillion to a total of $ 31.381 trillion on 16th December, 2021. As we are all aware that on 19th January, 2023, the Debt ceiling breached $31.381 trillion (it is $31.458 trillion while writing this article). After this, the Treasury announced the ‘extraordinary measures’ to borrow additional funds without breaching the debt ceiling (under the prescribed norms).

If the debt limit is not raised or suspended before the exhaustion of extraordinary measures then the government would be unable to pay its obligations in full. This will result in a delay in making payments for some activities, default on debt obligations or both.

Where does the debt come from?

In the past 50 years, there will be a handful of years when Government expenditure didn’t exceed revenue. In other words, the income from taxes is less than government spending. The increase in spending in recent years has occurred not only due to Iraq and Afghanistan war, combating Covid-19 but also the health cover costs of the ageing population along with funding to all the other services from highway construction to national parks.

At the same time, the revenue from taxes hasn’t kept pace with government spending. The tax increases were passed during 1998 and 2001, which helped to achieve a rare budget surplus.

What are the types of government spending?

It is important to understand that there are two types of Government spending. They are i) mandatory spending and ii) discretionary spending.

• Mandatory Spending: This spending comprises 63% of the overall budget. The major federal programs like Social Security and Medicare, fall under Mandatory Spending. These programs operate on autopilot mode (i.e.) they don’t have to be approved every year.
• Discretionary Spending: Other programs apart from the above fall under “discretionary” spending. The spending on this is about 30%. The spending on these programs is decided every year, from how much to whether to continue funding the programs or not.

What are the biggest contributors to the debt?

Most of this spending goes to defence (mostly half of it). The other major contributor to this Discretionary spending is interest on the debt.

How does the U.S. finance its debt?

The U.S. finances its debt through government bonds backed by the Treasury Department which are sold to domestic as well as foreign investors. These are sold through the U.S. Treasuries.

Who owns the debt?

The debt is owned by either domestic or foreign investors. Around one-third of total public debt is comprised of debt held by governments in other countries; Japan and China are at the top of the list in this regard.

How much cost is paid on the debt?

To maintain the debt it costs $ 307 billion, as of February 2023, which is 12% of the total Federal Spending. Over the past decade, the national debt has increased. During this period, the interest rate payments remained fairly stable due to low-interest rates. Recent, increases in interest rates along with inflation are now increasing interest payments/expenses.

If interest rates stay low over time, then the federal government will maintain the same level of interest payment and expenses on the debt it owes, despite the fact that the debt will continue to grow. When the interest rate increases, the cost of maintaining the debt also increases.

What would happen if the U.S. defaulted on the debt?

This has never happened though the U.S. has come near default. However, the present situation poses a threat of reaching it. The Actual default will be very worse. If a default happens then it will eventually result in a recession.

Is paying down the debt a good thing?

Many may think or even answer themselves, Yes, it is a good thing. Surprisingly, it is not so.

To understand this we need to look back to the 2008 financial crisis. This was not a result of some decisions made in that particular year, but the results of decisions made earlier. The federal government was paying down its debt too quickly in the late 1990s. This resulted in lack of availability of treasury bills, in later years, which forced or pushed investors into certain mortagage-backed securities which later became lethal for the economy.

So, it is not simple or easy to say paying down a debt is a good thing. The Banking sector needs treasury bills to sell to investors, and individuals. Without debt, the economy can be halted and may result in recession or financial crisis.

What is U.S. Debt-GDP Ratio?

Debt is mostly measured in terms of percentage to GDP and known as the Debt-to-GDP ratio. The U.S. Debt to GDP ratio is better than Japan and Italy but more or less the same as Canada, France and the United Kingdom. The U.S. Debt to GDP ratio has crossed 100% in 2013. As of December, 2022, the Debt-to-GDP ratio is 124%.

Conclusion

An economy is as strong as it has the potential ability to repay its debt. The U.S. is one among them (at least so far), as they never defaulted in terms of Debt. Therefore, it is important for the Congress take a well-decisive action sooner than later to not only avoid default but also to stop adding fuel to the ongoing banking crisis. Else, this may result in a deeper financial crisis or even a Recession. With the present banking crisis and inflation, which are already giving headaches for policymakers, we hope that the government finds a solution to this issue soon to avoid further economic problems.

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