US debt ceiling and Govt Shutdown: Why Government in biggest economy in the world facing Defaults?

Finvest - Finance & Investment Club of IIM Trichy

7 min readNov 9, 2021

If you are new to the world of finance and have been following the news lately you might be wondering how can the government of the largest economy in the world what are debt ceilings you are not alone. Read this article to find out.

What does the term “debt ceiling” mean?

It’s a cap on the amount of money the federal government can borrow (although some states in the US have debt ceilings as well). To put it another way, the debt ceiling is the maximum amount of debt that the federal government can add to the national debt in order to meet its financial obligations.

What exactly is the issue?

The United States has a budget deficit, meaning it spends more than it receives in taxes and other sources of revenue. As a result, it must borrow a substantial sum of money each year to pay its bills. The largest chunk of the federal budget in the United States goes to funding Social Security programs like Medicare and Medicaid, interest on the national debt (which, according to sources, is well over $28 trillion), salaries for federal employees and troops, and defense (which is in the range of $600–900 billion, more than twice that of China).

Every year, the US government borrows money to cover its budget deficit, and the national debt grows along with it. Since 1939 (when Congress enacted a statute restricting the amount of debt the government may take on), this limit has been suspended or raised 98 times to meet growing federal debt levels and allowing the government to function.

What’s the current issue all about?

The debt ceiling was suspended in 2019, enabling the debt to rise until July 31, 2021. According to the Peter G. Peterson Foundation’s live tracker, the national debt is now extremely near to $28.4 trillion debt ceiling, leaving the federal government with few alternatives.

The Treasury Department is currently using so-called emergency “extraordinary measures” to pay down U.S. receipts since reaching the last debt ceiling at the end of July. Extraordinary measures allow the department to both conserve cash and draw down certain accounts without issuing new bonds. But those measures are temporary and are only forecast to endure until mid-October, according to Treasury estimates.

The treasury could exhaust the cash reserves by 18th October 2021 and will default if this limit is not raised.
-Janet Yellen, US Treasury Secretary

What happens if the Debt Ceiling is not raised?

It would have serious effects on individuals as programs such as Medicare and Medicaid will run out of funding and federal government will be unable to pay its troops and other personnel. More importantly, it could leave United States unable to pay interest and maturities on Treasuries and US will default on its debt obligations.

US Treasury bond is considered as one of the safest assets for International Investment and is used as a benchmark in calculation of risk-free rate and risk premium by financial Experts worldwide. So, a default would disrupt the capital markets in the United States and all over the world. In September 19 Wallstreet article, The United States Treasury secretary Janet Yellen said,

“ Failing to raise the debt limit would produce widespread economic catastrophe and likely precipitate a historic financial crisis. U.S. faces a recession if Congress doesn’t address the debt limit within 2 weeks”

Potential results could include sell-off in Treasuries, which could drive up interest rates making it more expensive for government, business and consumers to borrow money. Investors might lose the confidence in the dollar as well leading to wide spread inflation and ultimately a meltdown of current capital markets and global economy as we know it.

According to a Moody’s report last month, a failure to raise the debt ceiling could lead to loss of almost 6 million jobs with unemployment rate rising to 9% (Second blow to economy that is still on its way to recovery from Covid-19), spike in interest rates of mortgages, consumer loans and business debts and could trigger a stock sell-off that would wipe out $9 trillion worth of households and investor’s wealth.

So, in essence, if you belong to ordinary US household, chances are you might lose your job at a time when your mortgage rates increase (or rent if you are living in rented accommodation), your equity investments might loose their value due to a mass selloff and funding for federal programs such as Medicare and Medicaid run out (which may put added burden on your shoulders to take for elderly and vulnerable).

Also, unlike previous economic crisis, the world is yet to fully recover from Covid-19 pandemic, numerous mutants of the Covid-19 are emerging every day with increased infectivity and increasingly high tolerance for Vaccines. So, if there is mass unemployment and people flock to the streets, Covid might become resurgent and complicate matters further.

Why is there a lock-Jam in Congress on raising the Debt Limit?

The US is heading for mid term elections on November 8, 2022. During this midterm election year, all 435 seats in the House of Representatives and 34 out of 100. Biden government is still recovering from Afghanistan debacle and Republicans can sense blood. They feel this is a chance for them to bounce back after the former President Trump failed to get a second term in the office (only the 6th President in US history to not get reelected).

Senate minority leader, Mr. McConnell has long used the periodic need to raise the government’s borrowing limit as a moment of leverage to secure a policy win, as have leaders of both parties. On October 4th 2021(two weeks from impending default) in his letter to the US President two weeks before a potentially catastrophic default, Mr. McConnell wrote “We have no list of demands.” According to New York Times,

The Senate minority leader appears to want to sow political chaos for Democrats while insulating himself and other Republicans from an issue that has the potential to divide them.

Hardball tactics by Republicans on the debt ceiling are not new. A new Republican House majority in 2011 pushed the government so close to default that Standard & Poor’s downgraded once-unassailable U.S. debt, but it also produced the Budget Control Act, which crimped spending for years.

This highlights the issue that there is a constant buildup of systemic risk (worth over $28 Trillion!!) as parties adopt more hardline approach and an impending doom of Accidental Default cannot be completely ruled out. This is especially significant as US is the largest open economy in the world and US debt accounts for over 40% of global GDP.

What are the options with US?

$1 Trillion Coin

The US treasury has the power to issue platinum coin of any denomination. During the Obama administration an option of issuing $1 Trillion coin and depositing it to the Federal Reserves was considered. This would allow the government to pay for additional bills till the time the debt ceiling is raised. Since, the coin is effectively not in circulation it is unlikely to lead to any inflation and when the debt ceiling is raised the treasury could just raise the debt of equivalent coin value.

But this wasn’t acted upon during the 2011 debt crisis as then US President considered the idea to be too absurd.

14th Amendment

Section 4,of the 14th Amendment of US constitution says the following:

Validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.

The government could use this to circumvent around the debt ceiling and treasury could keep borrowing to fund the US government. But this is highly likely to be challenged in courts especially by Republicans who wants concessions from the government to raise the debt ceiling.

Democrats can Unilaterally Raise the Debt Ceiling:

According to the senate minority leader Mr. Mitch McConnell, the democratic party could unilaterally raise the debt ceiling on their own without the support of the republicans. But, leaders of the democratic party argue that avoiding US default is a national issue so there must be bipartisan effort to raise the debt ceiling.

Broker a deal for Bipartisan effort to raise the debt ceiling:

This is the most likely option out of the all, but the main bone of contention here is $3.5 Trillion Infrastructure Package that is being proposed by US President Biden. The Republicans feel that such a massive spending right before the mid-term elections could hurt their chances in the US mid-term elections coming next year on Nov, 8 2022.

They are betting on the fact that the government must give some concessions and are using debt ceiling as a leverage. Or the government would have to take a unilateral route to raise the ceiling both of which could improve their chances in the mid-terms.

Conclusion

It is highly unlikely that the US defaults on its debt obligations and just like 98 other times since 1939, the US government will find a way to either suspend or raise the debt ceiling. But it cannot be denied that the recent political development in the US has led to substantial rise in systemic risk associated with the global economy. The fact remains that an event of Accidental Default by the US cannot be ruled completely ruled out.

Even if the US government manages to finds a way to raise the Debt ceiling, the world keeps a close and watchful eye on whether they do it with minutes to spare or a week. Meanwhile, there is likely to be severe implication for the debt markets and increased volatility is the Global Equity markets as the US government scrambles to avoid the default.