LondonFinance1
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You will have come about the term “debt ceiling” in recent news https://www.bbc.co.uk/news/business-65522169 – so what is it all about and why does it matter? Although it is a concept in US domestic politics, its repercussions could be felt across the globe.
The debt ceiling is the legal cap that the US Congress sets on the amount that the US Treasury can borrow. It does not authorise any new spending or taxes; it simply lets the government pay for what Congress has approved. The debt ceiling was introduced in 1917; before then, Congress tended to authorise borrowing only for specific purposes which is not really helpful in complex economic systems. But when raising money to support America’s entry into the first world war, Congress granted the Treasury more flexibility, eventually setting a comprehensive debt ceiling in 1935.
For a long time, setting this ceiling was a pro forma exercise. Since 1960, it was raised around 80 times, irrespective of who was sitting in the White House. Even during Donald Trump’s presidency, a bipartisan congressional majority raised the ceiling three times, and Democrats agreed to a two-year suspension of the ceiling as part of a budget agreement in 2019 which since then has expired. The current ceiling for gross debt is USD 31.4trn (or 117% of GDP), and America is getting closer to it. On May 1st Janet Yellen, the treasury secretary, warned that the government was set to exhaust its cash reserves and run out of budgetary gimmicks as soon as June 1st.
Once the Treasury cannot borrow any more money, it has to reduce or even stop (some) spending or default on its payment obligations. Even if you are in favour of reducing the state spending money, an abrupt reduction will be tricky. Imagine the government having to choose between paying pensioners, serving its existing debt, or spending on healthcare. Eventually, this could lead to a government shutdown in the US – in the 80s and 90s, these shutdowns lasted for a couple of days (or even just hours) and were almost part of political folklore, but there were some shutdowns that lasted longer and had some substantial effect. The last shutdown during the Trump years in 2018/19 lasted for 35 days. That lead to nine executive departments with ca. 800,000 staff members having to shut down partially or even in full. This affected roughly a quarter of all government activities and caused employees to be furloughed or required to work without being paid. The Congressional Budget Office estimated that this shutdown cost the US economy at least USD 11bn, not taking into account (far higher) indirect costs which are difficult to quantify. A significant reduction in public spending (even if it is just temporarily) could trigger a recession.
Does that matter to us in and around the Wharf? Can’t we just let the Americans to their political gambits? Sadly not – in short, cost of finance will go up at a time of interest rates that are already quite high (and should probably be even higher in the UK to combat inflation). The worst case would be defaulting (i.e. not paying interest) on Treasury securities. Like it or not, the dollar is the world’s reserve currency and much of the global financial system is built on the assumption that Treasuries are risk-free. If that assumption does not hold true anymore, lenders will ask for higher risk premiums, i.e. higher interest rates, to account for this risk. The last time America flirted with a default, Standard & Poor’s stripped America of its AAA rating. This in turn will raise interest rates as it is now official that the US is seen as a higher risk. For the UK, this could mean even higher interest rates (or rents as your landlord will pass his higher mortgage rates on to you) which in turn means less spending (more of your disposable incoming going towards mortgage payments rather than buying other goods and services) and/or increased prices (if you are paying more for rent, you will ask for a salary increase to make ends meet). You could see how the spiral could go on and on.
Even if nothing happens and Congress manages to raise the debt ceiling before a shutdown or a even default, its toying with disaster is as a stark warning about the deterioration of America’s fiscal health and the difficulty of recovering it. And this could well spread: investors might also doubt the safety of other (almost) risk-free assets, mostly bonds issued by government or big corporations and demand to be compensated for (perceived) higher risks, so cost of borrowing would increase across the broad. You might remember this from the sovereign debt crises in the early 2010s.
Given the highly polarised nature of US politics, a compromise by the remaining sensible Republican members of Congress might be described as treason by the (small, but extremly vocal) MAGA wing in the run-up to the presidential elections next year. It would also offer them the opportunity to paint Democrats as the party of irresponsible spending (not looking at the fact that raising the debt limit simply lets the government pay bills racked up under previous administrations). Democrats in turn would like to drive a wedge between the fractions of the Republicans and/or paint them as not fit for office, enforcing a shutdown for ideological reasons while the Democrats were reaching out across the aisle for a compromise in the interest of the country (who are the real patriots now?).
My guess is that there will be a last-minute compromise, maybe even a short shutdown, so that Republicans can save their face by proving that they can play hard, but after all only a handful of Republicans need to vote for a compromise to pass. A (very) short shutdown can be used to clear holidays or overtime, so might grap headlines, but would not be overly catastrophic. However, with enough turmoil in the markets at the moment, an early compromise would let us all sleep a lot better.
What is the likeliest outcome in your opinion?
The debt ceiling is the legal cap that the US Congress sets on the amount that the US Treasury can borrow. It does not authorise any new spending or taxes; it simply lets the government pay for what Congress has approved. The debt ceiling was introduced in 1917; before then, Congress tended to authorise borrowing only for specific purposes which is not really helpful in complex economic systems. But when raising money to support America’s entry into the first world war, Congress granted the Treasury more flexibility, eventually setting a comprehensive debt ceiling in 1935.
For a long time, setting this ceiling was a pro forma exercise. Since 1960, it was raised around 80 times, irrespective of who was sitting in the White House. Even during Donald Trump’s presidency, a bipartisan congressional majority raised the ceiling three times, and Democrats agreed to a two-year suspension of the ceiling as part of a budget agreement in 2019 which since then has expired. The current ceiling for gross debt is USD 31.4trn (or 117% of GDP), and America is getting closer to it. On May 1st Janet Yellen, the treasury secretary, warned that the government was set to exhaust its cash reserves and run out of budgetary gimmicks as soon as June 1st.
Once the Treasury cannot borrow any more money, it has to reduce or even stop (some) spending or default on its payment obligations. Even if you are in favour of reducing the state spending money, an abrupt reduction will be tricky. Imagine the government having to choose between paying pensioners, serving its existing debt, or spending on healthcare. Eventually, this could lead to a government shutdown in the US – in the 80s and 90s, these shutdowns lasted for a couple of days (or even just hours) and were almost part of political folklore, but there were some shutdowns that lasted longer and had some substantial effect. The last shutdown during the Trump years in 2018/19 lasted for 35 days. That lead to nine executive departments with ca. 800,000 staff members having to shut down partially or even in full. This affected roughly a quarter of all government activities and caused employees to be furloughed or required to work without being paid. The Congressional Budget Office estimated that this shutdown cost the US economy at least USD 11bn, not taking into account (far higher) indirect costs which are difficult to quantify. A significant reduction in public spending (even if it is just temporarily) could trigger a recession.
Does that matter to us in and around the Wharf? Can’t we just let the Americans to their political gambits? Sadly not – in short, cost of finance will go up at a time of interest rates that are already quite high (and should probably be even higher in the UK to combat inflation). The worst case would be defaulting (i.e. not paying interest) on Treasury securities. Like it or not, the dollar is the world’s reserve currency and much of the global financial system is built on the assumption that Treasuries are risk-free. If that assumption does not hold true anymore, lenders will ask for higher risk premiums, i.e. higher interest rates, to account for this risk. The last time America flirted with a default, Standard & Poor’s stripped America of its AAA rating. This in turn will raise interest rates as it is now official that the US is seen as a higher risk. For the UK, this could mean even higher interest rates (or rents as your landlord will pass his higher mortgage rates on to you) which in turn means less spending (more of your disposable incoming going towards mortgage payments rather than buying other goods and services) and/or increased prices (if you are paying more for rent, you will ask for a salary increase to make ends meet). You could see how the spiral could go on and on.
Even if nothing happens and Congress manages to raise the debt ceiling before a shutdown or a even default, its toying with disaster is as a stark warning about the deterioration of America’s fiscal health and the difficulty of recovering it. And this could well spread: investors might also doubt the safety of other (almost) risk-free assets, mostly bonds issued by government or big corporations and demand to be compensated for (perceived) higher risks, so cost of borrowing would increase across the broad. You might remember this from the sovereign debt crises in the early 2010s.
Given the highly polarised nature of US politics, a compromise by the remaining sensible Republican members of Congress might be described as treason by the (small, but extremly vocal) MAGA wing in the run-up to the presidential elections next year. It would also offer them the opportunity to paint Democrats as the party of irresponsible spending (not looking at the fact that raising the debt limit simply lets the government pay bills racked up under previous administrations). Democrats in turn would like to drive a wedge between the fractions of the Republicans and/or paint them as not fit for office, enforcing a shutdown for ideological reasons while the Democrats were reaching out across the aisle for a compromise in the interest of the country (who are the real patriots now?).
My guess is that there will be a last-minute compromise, maybe even a short shutdown, so that Republicans can save their face by proving that they can play hard, but after all only a handful of Republicans need to vote for a compromise to pass. A (very) short shutdown can be used to clear holidays or overtime, so might grap headlines, but would not be overly catastrophic. However, with enough turmoil in the markets at the moment, an early compromise would let us all sleep a lot better.
What is the likeliest outcome in your opinion?