We explain why everyone is worried about the debt ceiling drama unfolding in Washington. Yes, your eyes are already glazing over, but we promise to keep short, jargon-free—and explain why America’s IOUs matter to all of us.
Researched by: Rachel John & Anannya Parekh
Ok, fine. So wtf is this debt ceiling?
Living in the red: Like all governments, Uncle Sam ‘earns’ money in the form of taxes and spends on all sorts of things—social security, defence etc. It typically spends more than it takes in—and hence, has a deficit. Over the past decade, the shortfall per year has ranged from $400 billion to $3 trillion.
The big spender: Government spending has been skyrocketing since the Afghan and Iraq wars—followed by the Great Recession in 2008—which hit tax revenues. Then came the pandemic—which required the government to spend on hefty economic stimulus packages. But the key reason for the ballooning deficit: tax cuts. US presidents since Ronald Reagan in the 1980s have been slashing tax rates to keep their voters happy. Most recently, the deficit jumped by $7.8 trillion thanks to a Trump tax package.
Issuing IOUs: In order to function, Uncle Sam has to borrow money. It does so by issuing securities like a Treasury bond: “This debt is like a loan: Investors trade cash for a promise that the government will pay them back with interest.”
Key point to note: The debt raises money to cover spending that has already been approved in the budget.
The debt ceiling: quite simply puts a limit on how much the government can borrow. Once it hits the cap, the government cannot issue any more securities to pay its bills. The current limit has been set at $31.4 trillion. The government already hit the ceiling back in January, but has been using “extraordinary measures” to keep functioning. Basically, the Treasury has been moving money around to avoid blowing past the cap:
That includes seeking out ways to reduce what counts against the debt limit, such as suspending certain types of investments in savings plans for government workers and health plans for retired postal workers. The Treasury can also temporarily move money between government agencies and departments to make payments as they come due.
Raising the roof: Typically, when the government hits the debt ceiling, Congress will vote to increase the cap—so that it can issue more securities to pay its bills. This is hardly unusual. The debt ceiling has been raised 78 times since 1960 and 102 times since World War II. Most recently, Democrats voted with Republicans to raise the ceiling thrice for the Trump administration—with no strings attached.
But, but, but: The Republicans are refusing to do the same for the Biden White House.
Umm, why? What’s their problem?
The looming deadline: The Treasury Secretary Janet Yellen has warned that the government could run out of money as early as June 1. Sometime next month, the government will no longer be able to pay its bills without issuing more securities—i.e taking on more debt.
The big GOP play: Republicans want to use the looming deadline to extract spending cuts from the Democrats. They have not specified exactly what they want but a debt ceiling bill passed by the GOP-controlled House points to some likely targets:
- Cut most of the $80 billion in new funding for the Internal Revenue Service to improve tax collection and enforcement.
- Repeal energy and climate tax credits passed by Democrats—and replace them with incentives for the oil and gas industry.
- Block the Biden big plan to offer loan relief to college students—clawing back $460 million.
- Reduce spending on benefits such as Medicaid and food stamps—by toughening eligibility requirements.
Point to note: The bill has no chance of passing the Democrat-controlled Senate but it allows the Republicans to set the terms of the negotiations. Nor is it likely that the Biden White House will accede to this lengthy wishlist. As the New York Times notes:
A bill to raise the debt ceiling that House Republicans passed last month, which House Speaker Kevin McCarthy describes as the party’s negotiating position, is more in the nature of a demand for unconditional surrender. It would require Democrats to accept a long wish list of Republican priorities, including deep cuts in federal spending, and to accept the reversal of recent victories, including investments in tax enforcement and green energy. All for less than a year of peace before the government would hit the debt ceiling again.
Where we are now: President Biden and House Speaker Kevin McCarthy had a high-stakes meeting that failed to produce a deal—but both sides said it represented a step forward. They seem to agree that forcing America to default on its bills is not an option. But there is no indication how they plan to bridge the yawning gap between their political positions. Any compromise will take at least a couple of days to be passed by Congress. That means both sides are running out of time.
Also looming large: The presidential elections slated for 2024. Biden is already accusing the Republicans of playing dirty:
I think there are some MAGA Republicans in the House who know the damage it would do to the economy, and because I am president, and a president is responsible for everything, Biden would take the blame and that’s the one way to make sure Biden’s not reelected.
But the White House is also using the debt ceiling tamasha to score brownie points: “If there is no default, White House aides believe the voters will once again ignore how the legislative sausage was made and give Biden credit for his leadership through the crisis.”
So what’s the worst that can happen?
All hell will break loose—all around the world—if the default extends beyond a few days. The US government will not be able to pay its bills for the very first time in history—an unprecedented situation that no one knows how to handle. In fact, that uncertainty will likely escalate the levels of chaos and panic.
Domestic fallout: The first tremors will be felt on Wall Street:
The shock of a missed payment would ripple across the financial system — stocks, bonds, mutual funds, derivatives — before spilling out into the broader economy, experts say. Stocks would likely plummet on the expectation of a wider economic downturn, as interest rates rise and investors pull funds out of the market to preserve their access to short-term cash. A banking sector already wary of making new loans could tighten up further.
The last time the Republicans got into a similar standoff with the Obama White House, the major indexes plunged by 20%—a week ahead of the default date. This time, however, the markets have stayed relatively quiet—but that can change overnight.
The broader impact: Ordinary Americans who work for the government will feel the immediate pain—when their employer can’t make payroll. This includes everyone from US military personnel to food safety inspectors and air traffic controllers. Also at risk of being cut off overnight: anyone receiving government benefits, be it Social Security or Medicare.
But if the stalemate continues, the misery will spread outwards—triggering the long dreaded recession:
A drop in household wealth across the country, caused by a sell-off on Wall Street, would reduce consumer spending, which would hurt businesses, too. And a spike in interest rates would make it harder to get a loan or start a small business. That could also crash the already cooling housing market… The construction industry and other sectors would feel the pain, too.
Data point to note Experts over at Moody’s say that even if the debt limit were breached for no more than a week, the U.S. economy would weaken with great speed—wiping out roughly 1.5 million jobs.
The global fallout: In the global market, the US government’s treasury bond is considered so safe that it is almost the equivalent of cash. If that T-bill suddenly becomes risky, then the entire financial system could be in peril:
The $24 trillion US Treasury market is the primary source of financing for the government as well as the largest debt market in the world. The Treasury market is the backbone of the financial system, integral to everything from mortgage rates to the dollar, the most widely used currency in the world. At times, Treasury debt is even treated as the equivalent of cash because of the surety of the government’s creditworthiness.
Now consider this: In just the month of June, more than $1 trillion of Treasury debt will come due. Also: the government has to make $13.6 billion in interest payments due—spread out over 11 dates: “that means 11 different opportunities for the government to miss a payment over the course of next month.” Or 11 times that the global financial markets risk being thrown into chaos.
Data point to note: Foreign governments and private investors hold nearly $7.6 trillion of US debt—roughly 31% of the Treasurys in financial markets. If a Treasury bond, bill or note loses its value, it will have a “catastrophic” effect on their financial health.
Dollar danger: 58% of the world’s foreign currency reserves are held in US dollars. The euro (20%) is a distant second—followed by the Chinese yuan (3%). More importantly, it is the currency of global trade: between 1999 to 2019, “96% of trade in the Americas was invoiced in dollars. So was 74% of trade in Asia. Elsewhere outside of Europe, where the euro dominates, dollars accounted for 79% of trade.”
While the dollar will not crash overnight, its value will shrink as the default continues. The greatest problem is that financial markets operate on an assessment of risk. If the dollar loses value,the level of uncertainty will shoot up—and so will prices:
What you'd have with a US default is suddenly investors panicking and they're wondering, 'Is Japan next? Is the UK next? Germany next? What else is going to be defaulted on'. We suddenly have to reprice everything and in economic terms it is a risk premium. You get a risk premium added to prices and therefore bread becomes more expensive.
The bottomline: It is unlikely that either the Republicans or the Democrats are foolish enough to force a default—not with elections looming in the horizon. But the debt ceiling drama ought to force all of us to consider just how dependent the world economy is on Uncle Sam’s well-being.
Reading list
The Guardian and Wall Street Journal (paywall) have the best explainers on the debt ceiling. Washington Post, New York Times and Associated Press lay out the doomsday scenarios. Politico has more on the political wrangling in Washington. Reuters looks at Biden’s options.
