The US Debt Ceiling Crisis Explained

At Sunday’s ‘Meet the Press’ interview, the US Treasury Secretary, Janet Yellen, confirmed that the federal government will be unable to pay its bills “as soon as June 1st”. If this unfolds, the government must make hard choices “about what bills go unpaid.”

In the meantime, Moody’s Analytics estimated that such a default would result in a loss of 7.8 million US jobs. However, due to debt ceiling doom and gloom becoming a political tradition, Moody’s assigned a 10% probability for the debt default breach to happen. 

Likewise, Deutsche Bank assigned merely a 2% possibility. What is causing this crisis to be then pushed into the public spotlight?

Debt Ceiling Explained

A universal truth for households worldwide is that budgetary constraints must be followed. Otherwise, there are two paths forward – cuts or loans. This is true for the US government as well. If spending is greater than revenue, this creates a deficit carried over into debt.

The US debt ceiling is the amount of debt the federal government can take. Specifically, the total sum of debt held by the public and government accounts, such as Social Security and Medicare.

This concept was first introduced in October 1917 with the Second Liberty Bond Act. Before this law, Congress could authorize the government to borrow more. 

After such a specific debt was repaid, the government could not borrow again until another Congressional approval was granted. With the new law, this practice shifted to continuous government debt rollover without congressional approval. 

At the time, President Woodrow Wilson justified the Second Liberty Bond Act as a necessary measure to bring World War I to closure without waiting for lawmakers to act. 

Debt Ceiling Turning into Debt Ladder

By the very nature of politics, politicians get elected by promising improvements. But as taxpayers pay these goodies, raising taxes would be unpopular. Instead, politicians rather pick the path of debt more often than not.

In modern history, such practice has skyrocketed. Since 2001, Congress has modified the debt ceiling 15 times, resulting in a rapid debt increase, at $30.9 trillion in debt outstanding as of fiscal year 2022. 

To put it differently, the debt-to-GDP ratio went up to 124%. This means the country’s economic output is increasingly siphoned into debt repayment instead of productive activities. Consequently, this development puts into question the sustainability of the very monetary model in play.

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Net Interest Costs to Become One of the Largest Expenditures

In February, the nonpartisan Congressional Budget Office (CBO) released its economic outlook for 2023 –  2033. During the period, federal debt is projected to increase by an average of 2% per year, eventually reaching 195% of GDP by 2053.

Conversely, the net interest costs on debt repayment are projected to balloon to $10.5 trillion for 10-year interest costs between 2024-2033. At the same time, the cumulative total deficit for the 2023 – 2032 period is expected to reach $18.8 trillion, $3.1 trillion more than previously expected.

In April, the House Republicans passed a bill to increase the debt ceiling by $1.5 trillion, as noted in the CBO’s chart above. It would expire on March 31st, 2024, or until the funds are spent. The point of friction lies in spending on social programs. 

By CBO’s projections, spending on net interest, without severe cutting in other areas, will eventually outspend Social Security and Medicare by 2053, with revenue (tax receipts) failing to keep pace. For instance, Medicare alone would go from 2022’s $937 billion to $2 trillion by 2033. 

To divert the road to economic unsustainability, Republicans have reportedly introduced several measures in the $1.5 trillion debt ceiling raise:

• Undoing green energy tax credit
• Increasing fossil fuel production in more areas.
• Conditioning welfare cheques with more working hours.

President Biden called these and other measures “extreme positions” on Sunday. 

“It’s time for Republicans to accept that there is no bipartisan deal to be made solely, solely, on their partisan terms. Now it’s time for the other side to move from their extreme position.”

Underlying Mechanism of Debt Issuance

Although the federal government can be compared to an ordinary household, the analogy ends with debt issuance. The US Treasury, as the manager of federal expenditures, issues debt as T-Bills. The central bank, the Federal Reserve, then buys these debt securities, giving out interest yield in return. 

However, when the Fed buys T-Bills, it effectively increases the money supply, otherwise known as money printing (electronically). Between 2020 and 2022, the Fed increased M2 money supply by 39%, which triggered 40-year high inflation. 

Therefore, the cost of issuing more debt translates to currency debasement, manifesting as higher prices of goods and services. But to rectify inflation, the Fed initiated an interest rate hiking cycle. In turn, investors are paid more for them buying US debt. 

Ultimately, this means that the entire monetary model depends on the US Treasury paying its interest on the debt. Otherwise, investors would see US debt as bunk. If that were to happen, the Federal Reserve’s monetary policies would be severely limited. 

Debt Default Implications

Not only would the dollar weaken, increasing the cost of imports, but the Fed would have to increase interest rates even higher to attract buyers. Of course, this would further increase higher debt payments and borrowing costs. 

More importantly, the weakening of the US dollar could erode its global reserve currency status (GRC), limiting the US’ ability to export domestic inflation. The resulting domino effect would be so chaotic and severe that it could unravel the entire monetary system, as noted by Treasury Secretary Janet Yellen:

“A default would crack open the foundations upon which our financial system is built,”

Conversely, the political fallout would be just as chaotic if cuts happened in areas other than an interest in T-Bills. Given these high stakes, the debt ceiling is a valued political commodity.

Both parties are treating it as a tool to shift or affirm policies. By the same token, the likelihood of turning it into a chaotic weapon that harms the underpinning system they derive power is exceedingly low.

Do you think debt ceiling controversies will worsen as US debt increases, or will they lose traction by repetition? Let us know in the comments below.