Just like clockwork, the month of May signals the start of the discussion of the time-honored, yet persistently aggravating debt ceiling question. This issue, having been a thorn in every president’s policy making prowess, serves as a testament to why controlling both the Senate and the House remains paramount for either party. As it stands, the debt ceiling is at $31.4 trillion, representing 155% over 2023’s Q1 Real GDP and an increase of $2.5 trillion compared to 2021’s ceiling.

Throughout its history, the US has enjoyed ‘exorbitant privilege’ due to its position of being the reserve currency of the world. From the onset of the Bretton Woods Agreement, this arrangement has granted lower borrowing costs for the US and allowed other countries to gain access to more liquid, global credit markets. As a result, the US treasury markets have garnered a reputation of being the safest asset to invest in, exemplified by its nickname of the “risk-free rate” in the CAPM Formula.

Therefore, most of the world pays attention to Federal Reserve Press Conferences to gain a glimpse of the trajectory of US economic policies. For example, a developing country who has borrowed significantly from the US has to keep close tabs on the interest rate announcements and forward guidance provided by the Fed as this directly affects the greenback’s value.  Generally, higher interest rates lead to currency appreciation driven by foreign investors’ search for higher yields. Thus, the developing country would have to raise rates lockstep with the US, or face paying back loans in more expensive dollars.

Now, the media has been laser-focused on the so-called X-date. This is the day the US would fail to pay its bills on time. It is generally agreed that this day would arrive on June 1^st, which gives the government little time to reach a consensus. Before we delve into the practicalities of a default, we must understand who and how much these payments from the US governments go towards. Payments in the billions must be made towards Medicare and Medicaid benefits, veteran benefits, social security, civil pensions, Obamacare, SNAP food stamps, and interest payments on public debt. In addition, funding departments such as the defense, health and human services, education and agriculture also take a significant portion of budget. In aggregate, the US will spend $1.5 trillion more than it collects in tax revenue during the fiscal year of 2023, and the ceiling will have to be raised by that exact amount, or more, to prevent a default on US debt.

The current situation appears to be worse than previously thought. During negotiation sessions on May 19^th, speaker of the House Kevin McCarthy has left investors and speculators wondering if a deal could be struck before June 1st. Several leading Republican figures, including Louisiana Congressman Garret Graves, walked out of the conference room, claiming discussions should be “paused” after neither side compromised on key issues. Even if the ceiling is raised, the US is only delaying the inevitable, buying time until the issue resurfaces again. Thus, scrutiny must come from within the current structure of the government, to reassess options and find a pathway to out of this feedback loop. However, it remains extremely hard to gain an edge and invoke aligned policies in such a bipartisan world.

In my opinion, it is far too late for institutional change on the national level. With the clock ticking, the only option is to raise the debt ceiling by the required amount before the June 1^st deadline. In the longer term, even though I see merit on both sides of the debate, I think a line must be drawn of the budget of said initiatives to prevent excessive leverage for the US government. Having passed some of the highest spending packages during COVID, the US must compensate with spending cuts now. McCarthy has argued these cuts should come at the expense of education loans and climate change initiatives, but I think the bloated military and defense budget should be targeted first. These measures would allow the US to inch towards a balanced budget once again.

A default would be disastrous, not only affecting people invested directly in the treasuries market, but also foreign investors and governments alike. In 2011, when the crisis was narrowly averted, the US faced a credit downgrade and the Dow Jones fell by 2,000 points. I suspect a similar scenario would unfold in this case, perhaps even worse. In addition, recessions in developing countries and bankruptcies of companies who hold US-denominated debt would likely unfold. The value of US dollar and global stock exchange values would plummet, and the dollar’s supremacy as the reserve currency would be questioned, making it costly for the US to borrow. However, a silver lining would emerge, just as the 2008 crisis, credit default swap contracts would be triggered, providing windfalls for those who have bet against the market.

Despite all this, Biden remains hopeful as he says: “Every leader in the room understands the consequences if we fail to pay our bills. The nation has never defaulted on its debt, and it never will.” However, given the current state of discussions, it will be interesting to see how the issue unfolds in the coming days against the backdrop of a G7 summit.

Sources:

https://www.washingtonpost.com/podcasts/post-reports/the-doomsday-scenarios-if-the-us-defaults/

https://www.ft.com/content/a65969b7-e0c6-4cd8-8f1e-81ee828f291b