United States: Debt limit reached; fractious negotiations over adjusting the debt ceiling to ensue
The U.S. government reached its legal borrowing limit in January.
Congress must now agree to raise or suspend the debt ceiling, but the polarized political landscape will complicate the talks.
Failure to adjust the debt ceiling could have severe economic consequences.
What happened: On 19 January, the nation reached its borrowing cap of USD 31.4 trillion. Treasury Secretary Janet Yellen announced a series of “extraordinary measures” which should allow the government to continue paying its bills until June. Even though that estimate could be conservative, in the absence of a bipartisan deal, the government will likely be unable to meet its financial obligations sometime in June–December.
The political situation: The Democrats hold the Senate, and the Republicans hold the House. Moreover, the Republican House majority is slim, and Speaker McCarthy is beholden to a group of Republican Congresspeople who are demanding tough spending cuts in exchange for raising the debt ceiling; President Biden and the Democrats are against such cuts. As such, an easy across-the-aisle compromise is not currently on the table.
The economic impact of no debt ceiling adjustment: Once Yellen’s “extraordinary measures” are exhausted, without a higher debt ceiling, the government will be forced to cut spending to match revenue. This would likely lead to the furloughing of government employees, deep cuts to Federal spending programs, the first-ever default on the U.S.’ public debt, credit rating downgrades and tighter financial conditions. That said, the Federal Reserve would step in to calm markets and could conceivably print money to pay the government’s debt obligations and thus avoid a default in the first place. Moreover, the economic fallout from the government running out of money would be so significant that it would likely focus politicians’ minds and hasten a deal on the debt limit.
On the possibility of Fed intervention, ING analysts said:
“Federal Reserve printing could be employed as a safety net […], where politics makes a mistake, and the Fed steps in as a payer of last resort. The Fed could rationalise doing so as a means of protecting the system. It could certainly soften the impact and indeed could prevent a technical default in the first place. However, this would not be a structural solution. Moreover, it poses its own independent threat to the financial system as the US dollar is undermined by monetary financing of the national debt.”
The economic impact of a debt ceiling adjustment: If enough moderate Congressional Republicans ally with the Democrats, the debt ceiling could be raised with no strings attached. However, if Republican party discipline holds, a bipartisan agreement on the debt limit would likely involve some commitment to reduce the fiscal deficit over time, sapping domestic demand. Moreover, if a deal is only reached at the last minute, markets and economic agents would still grow jittery as June approaches, with consequent declines in stock markets and economic sentiment and increases in Treasury yields; the former could weigh on private spending and investment, and the latter would raise government borrowing costs.
On the outlook, the EIU said:
“We ultimately expect a deal to be reached to raise the debt ceiling, given the severe consequences of a US debt default. A last-minute compromise remains the most likely scenario, given the depth of partisan tensions in Congress. As a result, brinksmanship over the debt ceiling will increase economic uncertainty in the coming months and distract lawmakers, weakening government effectiveness.”