Thursday, October 17, 2013


What is the debt ceiling?

The debt ceiling is a self imposed limit for US Government borrowing. How much the US can borrow is set by legislative procedure. Both houses must vote and determine a limit. Currently, that limit is nearly $17 trillion. That limit ran out in May 2013 but the US Federal Reserve has managed to run the economy without borrowing more by using some other measures. However, the Treasury Secretary has said that these measures will be exhausted by Thursday and the Government will need to borrow more. With only a few hours to go the Government must vote to increase debt ceiling.

Why does the US keep hitting the debt ceiling?
Between 1940 and January 2013, the debt ceiling was raised 94 times. During President Reagan’s term, the ceiling was raised 18 times – the maximum. And so far, during President Obama’s term, it has been raised 6 times. You probably remember reading about frequent debt ceiling debates in the recent past. What has lead to this recent frequency of increasing the debt ceiling?

While US has been borrowing for a long time, the recent events can perhaps be traced back to the financial crisis of 2008. (Read a detailed explanation of that crisis here) After the 2008 sub prime crisis exploded, the US economy was weak and the Government had to revive it. It decided to dole out money through stimulus packages. But the Government didn’t have enough money in its kitty for these packages so it decided to print dollars. Failing companies were given money to survive; people were given money to spend. At that time, the crisis was controlled.

But the doling out of money was just a temporary solution. It only prevented a further fall. The fiscal stimulus did not help promote industry, did not help create jobs. All this while, while the US Government did not earn much by way of income, it still had the same level of spending to do to keep up the people’s standard of living. Remember that the country also fought two expensive wars during this period. All this lead to a widening deficit.

How does the US Government fund the widening deficit? It can raise taxes or cut spending but both are not very popular. It can also print money but it has already printed a lot and printing more can cause inflation. The last option, also the cheapest for the US, is to borrow and so the US borrows more and more. Who does it borrow from? From its own people (internal debt) and from other countries (external debt). The Government issues bonds to its people and to other countries and raises dollars. Right now, the US is a AAA rated sovereign. That means, it is has the best credit rating. People and countries believe that the US will not default in repaying borrowed funds. Because of this rating the US is able to borrow funds at a low cost. Countries like China that export heavily to the US tend to accumulate huge dollar reserves. They lend those dollars back to the US in exchange for treasury bonds.

Today, the US has borrowed so much that it repeatedly hits the debt ceiling.

To put it in numbers, here’s a look at the US economy (2012 numbers):
Total Revenues: $2.45 trillion (mostly taxes)
Total expenditure: $3.54 trillion (social security, defense, medicare, interest and other expenses like crude oil etc)
Deficit: $1.09 trillion
Accumulated Public debt: $16.68 trillion

Why is it so nail biting this time?

The US hit the debt ceiling in May 2013. But the Fed has managed to run the economy without borrowing more by using some other measures. However, the Treasury Secretary has said that these measures will be exhausted by Thursday. In order to raise the debt ceiling, the House must vote. But this time around, the Government is at an impasse. The Republicans and Democrats are at war over Obamacare. Neither party is willing to negotiate. The Government has been shutdown for the past few weeks because the two parties could not agree to a Budget. Read more about that here.

According to Moody's Analytics, a two-week shutdown would cut 0.3% off US GDP, while a month-long outage would knock a whole 1.4% off growth.

As revenues continue to deplete, the need to borrow more will only increase.

What happens if the debt ceiling is not raised?
If the debt ceiling is not raised, it means the US will not have money to bridge the fiscal deficit. It will not have money to pay its bills. This also increases the risk of default. A default means the US is not able to repay the principle and interest on its borrowings. If the US defaults, it will hamper its credit rating. Rating agency Fitch has already issued a warning on the US credit rating.

Apart from this, it would also send a signal to the rest of the world about a weakening US economy. A blip in the US economy, also called the world’s biggest buyer, will have an impact on world economy. So far, the US economy and therefore the US dollar was the single strongest currency in the world. Nowquestions are being raised about the efficiency of the US dollar as the universal currency.

We are back to the game of wait and watch. Hope this helps in putting some perspective into that game. Till next time, Money Happy Returns!

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