Every time the debt limit nears, a political dispute arises between the Democrats and Republicans over whether the debt ceiling should be raised or not. Such conflict threatens the stability of the financial system. Historically, the US has never defaulted on repaying its debts except for one instance in 1979, when payments were delayed owing to an inadvertent technical lag.
Usually, these tense negotiations last for several weeks and months, until a few days or hours before the debt limit comes to an end. This year's events are similar to those from earlier in 2011 and 2013, in which agreements between the two parties were reached during the last days. What happened in 2011 had prominent negative implications on the stability of the US economy as large credit rating agencies like Standard & Poor's downgraded the US credit rating from AAA to AA+, which means higher borrowing costs. Due to such uncertainty, for two months mortgage rates increased by 0.7 to 0.8 percentage points before gradually decreasing after that. Even more, during that time, the S&P 500 experienced a decline of nearly 17% between July 22 and August.
Recently, prior to reaching the X-date, credit rating agencies like Moody’s announced that any slight delay would be met with an immediate downgrade of the credit rating of US Treasury bonds. Such an announcement weakened market confidence, and as a consequence, investors were requesting a premium of 140 basis points for treasury bills maturing in June as compensation for bearing additional risk, and interest rates rose from 4.4% to 5.7%. All of this volatility in the debt and stock markets occurred while the US did not really default yet, so we can imagine how severe the crisis would be if the US failed to service its debts.
After months of opposition, on May 27, Biden and House Speaker Kevin McCarthy finalised a debt ceiling deal. The deal suspends the debt ceiling until January 2025, ensuring that such a dispute will not arise prior to the next election. The agreement also includes many terms that restrict governmental spending, as it sets limits on spending that is not related to national security, including areas like education and transportation.
The legislation imposes restrictions like keeping the level of fiscal expenditure constant in 2024, followed by an increase of no more than 1% in 2025. It also revokes around $28bn of the budget designated to recover from Covid-19 implications. Moreover, the deal imposes constraints on financial aid programs provided for needy families and student loans, as it also cuts around $1.4bn from Internal Revenue Service funding.
Such constraints on spending are expected to yield around $1tn in savings in the long run. Although it is anticipated that these savings will lower equilibrium real interest rates, which will eventually lead to lower interest rates. This decline in interest rates won't considerably increase consumption and investment because these factors are mostly driven by income and profitability. Thus, lower interest rates will fall to offset the slump resulting from lower expenditure.
What If the US failed to suspend debt ceiling and went default?
According to Moody's, a minor default would incur steep losses for the US and global economies, as they forecast that the GDP growth rate will drop by 4% and stock prices will experience a dramatic decline, resulting in the failure of many companies, which would be reflected in the loss of more than 6mn jobs. Moody’s also predicts that the world economy will also encounter a crisis similar to the financial collapse in 2008.
There are several possible scenarios in the event of a failure to raise the debt level. The US will be forced to print massive amounts of dollars to meet their liabilities as they have large amounts to be repaid soon; around $1tn needs to be repaid in June only, and the tax revenue is inadequate to fulfil such an obligation. Thus, printing a large amount of money will result in more inflation, followed by a depreciation in the value of the dollar. This may push the Fed to even raise the interest rate level to combat inflation, which will undermine financial stability as further bank runs will be expected since many banks hold large amounts of bonds. This increase in interest rates will devastate the value of these bonds and therefore create more potential bank runs.
Since many countries like Japan, China, the UK, Belgium, and GCC countries like Saudi Arabia and Kuwait hold large proportions of US debt, a depreciation of the dollar and a decline in the value of these bonds will result in steep losses on the holdings of these countries and many other countries, as the level of foreign debt is equivalent to around $7.4tn. Accordingly, this will cost the global economy trillions of dollars, which will reinforce the downturn the world is currently facing from the pandemic and energy crisis arising from the Russian-Ukrainian war, pushing the world towards a more severe recession.
Postponing the repayment of debt will also encourage many bondholders to sell their bonds, and therefore the value of these bonds will sharply decline. Such a decrease in the value of these bonds will contribute to the instability of the market as the value of the bank’s assets will shrink in value, resulting in a solvency issue that would also trigger bankruptcy.
To conclude, we can mainly attribute this dispute to political factors in order to limit governmental spending, as such constraints over expenditure will worsen the situation for the Democrats and be in favour of the Republicans in the upcoming election. We can also conclude that the US is unlikely to default as the main cause of opposition is related to politics, and what happens often is similar to what happened previously in 2011 and last year, where the agreements came on the last days. Furthermore, the global system is highly dollarised, meaning that the main reserve currency worldwide is the dollar, and nearly all commodities like oil, gas, and fuel are priced in dollars. Additionally, there is a large financial inflow towards the American economy, along with a large sum of dollar deposits worldwide, all of which contribute to the demand for the dollar. The dominance of the dollar makes the supply of dollars accommodative, which permits the US to continue issuing dollars and therefore makes a default unlikely.
Thus, investors shouldn’t be concerned about such an issue, as the dispute is probably considered a pressure tool, and according to the 14th Amendment, even if the negotiations fail, the US president is entitled to keep issuing more bonds.
Mohammed Fahad Hussain Kamal Alemadi is senior student at Qatar University studying Finance and Economics
