What is debt ceiling? Will The US default on its debt?

The economic situation in the United States has been a cause of worry for many analysts and investment firms, as the world’s largest economy is at the doorstep of defaulting on its debt! In case Congress does not decide to raise the debt ceiling.

The United States, like many other countries, is a deficit economy which means that the country spends more cash than it earns. In order to ensure that its financial commitments are met, the country borrows money through Government backed debt instruments like the 10-year treasury bill - the safest investment instrument in the whole world. 

There is a risk that the US might default on interest payments on its debt as early as next month ie June 2023 - something which has never happened before. 

There is a certain amount of gravitas to the situation because in case the US defaults on its debt, there could be a cascading effect throughout global equity, debt and currency markets. 

What is debt ceiling?

The concept of the debt limit, or ceiling sets the maximum amount of outstanding federal debt the U.S. government can incur. In easier terms, it is the maximum amount of debt the US Government can take on. 

In January 2023, the total national debt and the debt ceiling both stood at $31.4 trillion. According to think tank, Council for Foreign Relations, The U.S. Government has run a deficit averaging $1trillion every year since 2001. 

A point to note is - The Congressional action to elevate the debt ceiling does not result in an expansion of the country's financial obligations, as the decisions regarding expenditure are determined through separate legislative processes. Any alteration to the debt ceiling necessitates the approval of a majority in both houses of Congress.

Historically, the US has raised and narrowed the debt ceiling to suit its borrowing needs multiple times. 

Historic US Debt:

What is happening around the debt ceiling now?

Democrats and Republicans - the two dominant political parties in the US Parliament, have locked horns and remain deeply divided on how to move forward with the decision on the debt ceiling. 

President Joe Biden led Democrats want the ceiling raised to avoid a catastrophic default situation, while Republicans are against it. Democrats want to raise more debt and keep spending flat, while Republicans want to cut down overall Government spending. 

This standoff between the two parties has been ongoing for the past two months which has spooked Wall Street and pushed the cost of raising debt higher. 

The US Treasury Department has already issued a warning that the US could run short of cash to meet all its needs as soon as Jun 1, 2023. 

What are the implications if the US defaults on its debt?

Loss of Federal Benefits

The US in this case will find a way to cut down on all social security related expenses to concentrate on more fiscal matters. Invariably, this could lead to lesser spending capacity in the hands of the population at large in the US which could lead towards a drop in demand towards consumer discretionary spending. 

Recession and Job Cuts

If the US defaults on its debt, most investors and HNI’s will be the first to pull away all their wealth they invested in the country. 

Take the recent example of the failure regional banks in the US like First Republic and Silicon Valley Bank. Investors are the first to leave in such economical situations which will cause companies to lose working capital which in turn will land up in job cuts. 

Job cuts also equals lower consumption and a cut down on consumer spending which leads to a recessionary situation. 

Stock markets crash

The US Treasury is the safest investment and if investor wealth is not safe there, the stock market doesn’t even come close to the safety of US Treasury instruments. 

Naturally, investors and traders will pull out their investment from there to look for another investment avenues, albeit safer ones like the Japanese Yen or Gold. 

Emerging markets like India, Indonesia, Brazil will be more hit as investors will turn completely risk averse in case of a US default, which will lead to total pandemonium in global equity markets. 

What if the US debt ceiling is not raised?

That being said, the United States has never intentionally defaulted on its debt. Even if the debt ceiling is not raised, there are several fiscal decisions the US Government will enforce to ensure there is no default whatsoever.

This is not investment advice. Investments in the securities market are subject to market risk, read all the related documents carefully before investing. Past performance is not indicative of future returns.