10 things you should know about the US debt ceiling

The American government is staring at a big problem ahead. Come 17 October, and it will hit the debt ceiling set by the American Congress. If this happens it will have global implications. Given that, it is important to understand what the debt ceiling really means and how it can impact the whole world.

So what is the debt ceiling?

The American government, like almost every government in the world, spends more than what it earns. The difference between what it spends and what it earns is met through borrowing money. There is an overall limit to the amount the American government can borrow. This limit is currently set at $16.69 trillion.

So what will actually happen on 17 October?

The American Treasury Secretary Jack Lew (equivalent of the finance minister in India) has said that on 17 October, the Treasury department will run out of the extraordinary measures it had put in place to ensure that the government doesn’t cross the debt ceiling of $16.69 trillion. Since May 2013, Lew has taken a number of extraordinary measures, like delaying pension fund payments, to ensure that the government expenditure remains under control and hence, the government does not cross the debt ceiling.

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So the American government will run out of money on 17 October?

The answer to this question is not very clear. Lew has said that as on October 17, the government “will be left to meet our country’s commitments at that time with only approximately $30bn.”

And this amount will not be enough to meet expenditures of the government, which on certain days can be as high as $60 billion. He has not clarified the exact expected expenditure of the American government as on October 17. Hence, we don’t know if the American government will run out of money on October 17.

So when will the American government actually run out of money?

There are various estimates going around on this. Most analysts agree that the government won’t run out of money on 18 October, and will keep chugging along for a brief while.

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The Bipartisan Policy Center expects this date to be anywhere between 22 October and 1 November.

As it points out “Updated data on Treasury cash flows through the first week of October show that the range for the Bipartisan Policy Center’s (BPC) X Date - the date on which the United States will be unable to meet all of its financial obligations in full and on time - has narrowed to between October 22 and November 1.”

Economists at JP Morgan have come up with a more precise date of October 24th. As an article on Time.com points out “They (i.e. the economists at JP Morgan) write that it is “extremely unlikely” the Treasury will be able to make it’s payments more than a few days after the 24th, and that the Treasury would most certainly have to default on some payments by 1 November, when large outlays for Social Security, Medicare, retirement benefits for military and civil services workers, and interest payments are due.”

[caption id=“attachment_1162343” align=“alignleft” width=“380”]  What will happen on 17 October? AFP photo[/caption]

So what will be the impact of this?

The expenditure of the American government will be greater than its income. Until now it has been able to borrow money to finance the gap. It won’t be able to borrow any more. Given that, it will have to cut down on its expenditure.

As Eric Posnerwrites on Slate.com:

“If the debt ceiling is not raised, and the executive branch stops borrowing, the government will need to cut spending by about15 to 20percent-or almost 40 percent of spending on everything (yes, Medicare and defense) other than the interest on the debt.”

The impact of the cut in expenditure will be immediate. As Henry J Aaron writes in The New York Times"A decision to cut spending enough to avoid borrowing would instantaneously slash outlays by approximately $600 billion a year. Cutting payments to veterans, Social Security benefits and interest on the national debt by half would just about do the job. But such cuts would not only illegally betray promises to veterans, the elderly and disabled and bondholders."

Other than having economic consequences, this cut in expenditure will also have social consequences. As Mark Blyth writes in Austerity - The History of a Dangerous Idea in a slightly different context but still applicable in this case, “Seventy-two percent of the working population(in America) live paycheck to paycheck, have few if any savings, and would have trouble raising $2000 at short notice. There are, as far as we can tell, about 70 million handguns in the United States. So what would happen if…no paychecks were being paid out?”

Hence, cutting expenditure can have dramatic social and economic consequences.

So why is the American government doing nothing about this?

As must be clear by now the consequences of the American government hitting the debt ceiling and not being able to meet its expenditure, will be disastrous. Given this, why hasn’t the government done something about it? Why haven’t they increased the debt ceiling?

The answer lies in the fact that the two houses of the American Congress are currently in a logjam. The House of Representatives is dominated by the Republican Party and the Senate is dominated by the Democratic Party. And both the parties are refusing to talk to each other. The Republicans believe that fiscal profligacy of the American government has gone on for too long and needs to be reined in.

In fact, many Republican Congressmen are not concerned about the debt ceiling at all. As Senator Richard Burr recently said “I’m not as concerned as the president is on the debt ceiling, because the only people buying our bonds right now is the Federal Reserve. So it’s like scaring ourselves.”

So are Republicans right on only the Federal Reserve buying government bonds?

This statement has been true in the recent past. The Federal Reserve of United States, the American central bank has been printing money to buy American government bonds. This helps the government finance its fiscal deficit. Fiscal deficit is the difference between between what a government earns and what it spends.

But Burr’s statement does not take into account the fact that foreign countries hold nearly $5.6 trillion of American government bonds. In comparison, the treasury holds bonds worth $1.93 trillion. These bonds were issued by the American government to borrow money to finance its fiscal deficit.

Interest on these bonds needs to be paid. Also, maturing bonds needs to be repaid. The American government has reached a stage, where it pays the interest on bonds as well as repays maturing bonds, by raising money by selling new bonds and taking on more debt. Any decision to stop paying interest on bonds or default on maturing bonds, will lead to a global financial crisis.

As Posner writes: “If he(i.e Obama) stops interest payments, the United States will default. This will not only raise interest payments-costing taxpayers hundreds of billions of dollars-but could spark a financial panic like the meltdown of 2008.”

The US government bonds are the ultimate risk free asset. If the government defaults on interest payments and/or principal repayment, then investors all over the world are going to exit all kinds of financial markets. No wonder China which holds more than a trillion dollars of American government bonds is worried. The Chinese Vice Finance Minister Zhu Guangyao recently said “We naturally are paying attention to financial deadlock in the U.S. and reasonably demand that the U.S. guarantee the safety of Chinese investment there.”

So that brings us back to the question why aren’t Republicans and Democrats talking?

This basically boils down to the fact that Republican Congressmen seem to be confident that the government is in a position to work its way around the debt ceiling. As Senator Orrin Hatch recently said: “I think the administration could work on who gets paid and who doesn’t in a way that would pull us through.”

It is easy to ask the government to prioritize payments, but anything done around those lines could have serious legal implications.

It needs to be pointed out that there are no legal provisions to decide which expenditure should be cut first.

“There is no clear legal basis for deciding what programs to cut. Defense contractors, or Medicare payments to doctors? Education grants, or the F.B.I.? Endless litigation would follow. No matter how the cuts might be distributed, they would, if sustained for more than a very brief period, kill the economic recovery and cause unemployment to return quickly to double digits,” Aaron points out in The New York Times.

The politicians on both the sides are also taking it easy because the markets haven’t reacted to this lack of communication between the two political parties on the debt ceiling. As Senator Hatch put it “I don’t think the markets have been spooked so far, and I personally believe that if they realized there was a legitimate attempt to make the government work, they would be less likely [to be spooked].”

So why haven’t the markets reacted?

The debt ceiling has been in place since 1939. And since then the American Congress has raised it numerous times to allow the government to borrow more. As an article in the Christian Science Monitor points out “An overall cap on federal debt has been in place since 1939, and Congress has raised it numerous times since then.The Treasury Department counts 78 times since 1960.”

What has happened 78 times is also likely to happen one more time.

This explains why the various financial markets in America and around the world continue to remain stable and are not taking into account the possibility of another crisis.

As Bill Gross manager of the world’s biggest bond fund, told Bloomberg Television “The odds of a default are “a million-to-one” as the Treasury Department will be able to take other measures to ensure it is servicing the country’s debt.”

Hence, the market is currently expecting the Republicans and the Democrats to sit down and solve the problem before October 17.

So will the markets continue to remain stable?

That’s a tricky question to answer. The closer we get to 17 October without any solution in sight, the more the stability of the markets will be threatened. In fact, if the American stock market falls it might even get the Republicans and the Democrats to start talking.

As John Cassidy of The New Yorker magazines writes on his blog “If the market fell by, say, three or four hundred points for three days in a row, and then lurched down another eight hundred points, or even a thousand points, the effect would be salutary. How can I say that? Tens of millions of Americans would grow alarmed about their 401k plans. On Wall Street, there would be margin calls, liquidity runs, and other disturbing developments that inevitably accompany market breaks. Rumors would start to spread about the health of various financial institutions. You don’t have to subscribe to a tail-wags-the-dog view of finance and politics to believe that this would lead to a rapid change of thinking, and of behaviour, in Washington.”

This will get the two sides talking on the debt ceiling for sure.

Vivek Kaul is a writer. He tweets @kaul_vivek