Author: Rushabh Maru
After 2013 high drama between the Republicans and the Democrats, the debt ceiling issue is once again set to haunt financial markets all over the world. Before we discuss in length about the issue, first let us understand what debt ceiling is and why it is important. The debt limit is the total amount of money that the US government is authorized to borrow to meet its existing obligations. These obligations include social security and medicare benefits, military salaries, interest on the national debt, tax refunds and other payments.
When the ceiling is reached, the treasury department can no longer issue treasury bills, notes or bonds. Its only available action is to pay bills via tax revenue. If tax revenue is not sufficient enough to offset the costs, then the treasury secretary must choose which federal functions will continue to operate. The choice often comes down to paying federal employees, social security benefits or interest on the national debt. For this reason, the debt ceiling raises concerns about the federal government shutting down. Under Article I section 8 of the US constitution, only Congress can authorize borrowing of money on the credit for the US.
The issue is of paramount importance for the financial markets because if the current debt ceiling is not raised then America could default on its debt. If it happens then it would be unprecedented event in the history of the financial markets. To avoid this situation, the US has always raised the debt ceiling despite brawl. In 2011, the US reached a crisis point of near default on public debt. A delay in raising the debt ceiling resulted in the first downgrade of the US credit rating by S&P. This led to sharp sell-off in the stock market and increased borrowing costs.
The Congress raised the debt limit with the Budget Control Act of 2011, which added to the fiscal cliff when the new ceiling was reached on 31st December, 2012. Another debt ceiling crisis arose in early 2013 when the ceiling was reached again, and treasury adopted extraordinary measures to avoid a default. The debt ceiling would again have been reached on 3rd November, 2015. On 30th October, 2015 the debt ceiling was again suspended to 16th March 2017.
Since March 2017, the treasury department is using extraordinary measures to allow additional period of fully funded government operations. In September, the Congress raised the debt ceiling till 8th December, 2017 as hurricanes affected US economy. This provided temporary respite to the markets. However, recently the treasury department said that if the Congress fails to increase or further suspend the debt limit by 8th December, it can continue to take some temporary measures to finance the government only till January 2018. In that scenario the debt limit would be reinstated at over $20 trillion. Hence, by January 2018, if debt ceiling is not raised then the US would default on its debt.
Chart: Debt subject to limit and statutory limit on federal debt
Source: Peter G Peterson Foundation
Excessive debt creates a series of challenges for policymakers and the nation. It can impede economic growth and limit government ability to invest. A failure to raise the debt limit can lead to sovereign rating downgrade by rating agencies. US had faced similar situation in 2011 and 2013. During 2011, S&P had cut US’s sovereign credit rating to AA+ from AAA due to debt ceiling concerns. Similarly in 2013 too, the US was on the brink of government shutdown. After the global financial crisis of 2008, US debt to GDP has increased drastically.
Chart: US debt to GDP ratio
Source: Federal Reserve Bank of New York
Debt is rising at a rapid pace in recent years and currently stands at $20 trillion. In coming years, the debt to GDP ratio is projected to rise sharply. The projected rise in deficits is due to rapid growth in spending for federal retirement and health care programs targeted to older people. According to the CBO, by 2047, 22% of US population will age above 65 or older compared to current rate of 15%. Further, rising interest payments on the government’s debt accompanied by only moderate growth in revenue collection could push deficit higher.
Chart: Population by age group
CBO projects GDP growth in coming years would be slower than it has been over the past 50 years. Under its extended baseline, CBO projects an increase in real (inflation-adjusted) potential GDP of 1.9% per year, on average, over the next 30 years, compared with 2.9% over the past 50 years. That slower economic growth is attributable to several factors, notably the slower growth of the potential labor force (the labor force adjusted for movements in the business cycle).
The budget deficit has increased to 3.6% of GDP in 2017, from 3.2% in 2016. By 2027, the deficit is expected to rise to 5.2% of GDP. Debt held by the public could rise to 91% ($26 trillion) of GDP in 2027, from 77% of GDP ($15 trillion) in 2017. The debt ceiling has become the political issue in recent months. President Donald Trump has threatened to shut down the government to get funding to build wall near US Mexico border. Republicans have demanded any debt ceiling hike to be accompanied by spending cuts or fiscal reforms. On the other hand, democrats are demanding reauthorization of health insurance programs for low-income children.
Recently, Trump floated an idea of permanently remove the requirement that Congress repeatedly raise the debt ceiling. The alternative which is being discussed is to give full authority to the treasury to borrow as much as needed to pay the nation’s bill. In the earlier system, debt ceiling was automatically deemed to be increased with the passage of the budget. However, removal of debt ceiling requirement is easier said than done. Most of the Republicans are against this idea.
Chart: Projection of US government outlays and revenues
On top of this, president Trump plans to reform US taxation system. Trump wants to cut taxes for individual and corporates. If this happens then pressure on revenues would increase sharply and as a result, deficit could widen further. Hence, US should raise debt ceiling when it approaches. That could avert US government default on its debt. However, as a long term solution, any hike in debt ceiling should be accompanied by spending cuts.