The US could be close to reaching its debt ceiling.
Treasury Secretary Janet Yellen said last week that the US is likely to hit the ceiling on Thursday. Unless Congress takes action, the event “may cause irreparable damage to the US economy, the livelihoods of all Americans and global financial stability,” she wrote in a letter to incoming House Speaker Kevin McCarthy, R-Calif.
Here’s what the debt ceiling is and what makes it so important to consumers.
What is the debt ceiling?
The debt ceiling is the amount of money the US Treasury Department is allowed to borrow to pay its bills.
These obligations include Social Security and Medicare benefits, tax returns, military salaries, and interest payments on outstanding government debt.
The current cap is around $31.4 trillion. Once hit, the US will be unable to increase the size of its outstanding debt – and paying its bills will become more difficult.
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“Like many households, the government relies on debt to fund its obligations,” said Mark Hamrick, a senior economic analyst at Bankrate. “And like many households, it doesn’t have enough income to fund its expenses.”
The debt ceiling would not be an issue if US revenues – ie tax revenues – exceeded its costs. But the US has not posted a net profit since 2001 — and has borrowed to fund government operations every year since, according to the White House Council of Economic Advisers.
Why is the debt ceiling an issue right now?
While the US is expected to hit its $31.4 trillion borrowing limit on Thursday, that in and of itself is not the main concern.
The Treasury has temporary ways to pay bills: it can use existing cash or spend incoming receipts, such as during tax season, which begins Jan. 23.
It can also take so-called “extraordinary measures” that release funds in the short term. The Treasury Department will begin applying such measures this month, Yellen said. They include a redemption or suspension of investments in certain federal pension and disability funds. The funds would later be made complete.
These maneuvers are designed to prevent a potential catastrophe: a default.
A default would occur when the US runs out of money to meet all of its financial obligations on time — for example, missing a payment to investors holding US Treasury bonds. The US issues bonds to raise money to fund its operations.
The US defaulted on its debt only once, in 1979. A technical error in accounting led to delays in bond payments, a mistake that was quickly fixed and affected only a small segment of investors, the Treasury Department said.
However, the US has never “deliberately” defaulted on its debt, CEA economists have said. This result is what Yellen warned would do “irreparable damage”. The magnitude of negative shockwaves is unknown as it has never happened before, economists said.
“The implications are serious,” said Mark Zandi, chief economist at Moody’s Analytics.
“It would cause chaos in the financial markets and completely undermine the economy,” he added. “The economy would go into a severe recession.”
Fallout: Frozen benefits, a recession, more expensive credit
An exact default date is difficult to determine due to the volatility of government payments and revenues. But it’s unlikely to happen before early June, Yellen said.
Congress, meanwhile, can raise or temporarily suspend the debt ceiling to stave off a debt crisis — something lawmakers have done many times in the past. But the political impasse this time calls into question their ability or willingness to do so.
[A default] would wreak havoc on the financial markets and completely undermine the economy.
Markus Zandi
Chief Economist at Moody’s Analytics
A US default would send multiple negative shock waves through the US and the global economy.
Here are some of the ways this could impact consumers and investors:
1. Frozen federal benefits
Tens of millions of American households may not receive certain federal benefits — such as Social Security, Medicare and Medicaid, and federal assistance related to nutrition, veterans and housing — on time or at all, the CEA said. Government functions such as national defense can be adversely affected if, for example, the salaries of active-duty military personnel are frozen.
2. A recession with job cuts
Affected households would have less cash to pump into the US economy — and a recession “seems inevitable under these circumstances,” Hamrick said. A recession would mean thousands of lost jobs and higher unemployment.
3. Higher borrowing costs
Investors view US Treasuries and the US dollar in general as safe haven assets. Bondholders are confident that the US will return their money with interest in a timely manner.
“It is sacrosanct in the US financial system that US Treasuries are risk free,” Zandi said.
If that were no longer the case, rating agencies would likely downgrade US sterling’s creditworthiness and people would charge much higher interest rates on Treasuries to offset the added risk, Zandi said.
The cost of borrowing for American consumers would rise as interest rates on mortgages, credit cards, auto loans and other types of consumer debt are linked to movements in the US Treasury market. Companies would also pay higher interest rates on their loans.
4. Extreme stock market volatility
That assumes, of course, that businesses and consumers could get credit. There could also be a “major” financial crisis if the US government is unable to issue additional Treasury bonds, which are an essential part of the financial system, Hamrick said.
“A default would send shockwaves through global financial markets and likely cause global credit markets to freeze and equity markets to plummet,” the CEA said.
Even the threat of default during the 2011 debt ceiling “crisis” prompted Standard & Poor’s (now known as S&P Global Ratings) to downgrade the US credit rating and caused significant market turmoil. Mortgage rates rose by 0.7 to 0.8 percentage points for two months and then slowly fell, the CEA said.
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