What is the US debt-ceiling crisis?

Australia on Wednesday (May 17) had to cancel the upcoming Quad (US, Japan, India, Australia) summit in Sydney after US President Joe Biden cut short his Asia tour due to debt ceiling negotiations in Washington.

Biden will return to Washington on Sunday, after Speaker of the US House of Representative, Kevin McCarthy, offered a hint that lawmakers were moving towards a deal to raise the debt ceiling, reported the Financial Times.

What happened?

On January 19, 2023, the US government hit its $31.38 trillion debt ceiling and since that it has not been able to borrow more money.

America may default on some debts unless the US Congress votes to lift the debt ceiling of the country. Many economists are fearing that the US might slide into a recession and affect the global economy.

But, what is a debt ceiling?

The debt ceiling refers to a legal limit on the amount of debt that the government of a country can incur. It is a restriction imposed by legislation that sets a maximum level of outstanding debt that the government can borrow to finance its operations and meet its financial obligations.

The US government, like most other governments around the world, other than collecting money from taxes, borrows money to meet its spending commitments like paying federal employees, military, Social Security, Medicare etc.

The national debt is similar to a person using a credit card for purchases and not paying off the full balance each month. The cost of purchases exceeding the amount paid off represents a deficit, while accumulated deficits over time represents a person’s overall debt.

In the case of the United States, the debt ceiling is a statutory limit established by Congress on the amount of money the federal government can borrow. It sets an upper bound on the total amount of outstanding public debt that the US Treasury can issue to finance the government's activities, including paying its bills and obligations.

What happens when a country reaches the debt ceiling?

When the government reaches the debt ceiling, it cannot issue any more debt to meet its financial needs, potentially leading to a situation where the government cannot pay its obligations or run out of money to fund its operations.

To avoid a default on its debt and a potential financial crisis, the government must either reduce its spending, increase its revenue, or raise the debt ceiling by passing legislation.

Has the US reached its debt ceiling?

According to the US Today, the debt ceiling has already been reached and the US government hit its borrowing limit in January. Since then, Treasury Secretary Janet Yellen said "extraordinary measures" have been taken so the country can pay its bills and avoid default. The cap currently stands at roughly $31.4 trillion.

In the context of government debt, a default happens when a government is unable to make interest payments or principal repayments on its outstanding debt.

What happens if the debt ceiling isn't raised and US govt defaults on the debt?

The US government has never defaulted on its debts and this is the reason why US Treasury bonds are viewed as a safe investment. But, if it happens, it would create a financial crisis.

In 2013, the US government was very close to a default before it raised the debt limit at the last minute. The US economy lost 1% of its GDP at that time, reported the US Today.

If the US government defaults on its debt, it would no longer be able to pay the salaries of federal and military employees, issue Social Security cheques and the private companies and charities that depend on the government would no longer exist.

Moody's Analytics predicts that in a prolonged stand-off, stock prices would fall by almost a fifth and the economy would contract more than 4%, leading to the loss of more than seven million jobs, reported BBC.

WATCH: US President Joe Biden held a meeting with Republican leaders to discuss raising the debt ceiling to avoid a default https://t.co/3gK7Y0rppH pic.twitter.com/I9J6LDVd8I

— Reuters Asia (@ReutersAsia) May 17, 2023

How would a US debt default affect the global economy?

A US debt default would have significant implications for the global economy due to the central role of the United States in the international financial system. It has the potential to cause a global recession. Here are some potential effects of a US debt default on the global economy:

Financial market turmoil: A default by the US government would cause severe turmoil in global financial markets as US Treasury securities are widely held by investors around the world, and they serve as a benchmark for other financial instruments.

Increased borrowing costs: A US default would raise borrowing costs not only for the US government but also for other borrowers worldwide. US Treasury securities are considered a risk-free asset, and their yields serve as a reference point for interest rates globally.

Loss of investor confidence: The US dollar is the world's reserve currency, and US Treasury securities are considered a safe haven investment. A default would erode investor confidence in the US dollar and US government debt. This could lead to a loss of trust in the global financial system.

Weakened economic growth: Financial market volatility, increased borrowing costs, and reduced investor confidence would ultimately impact business investment, consumer spending, and overall economic activity and it would lead to a weakened economic growth worldwide.

US President Joe Biden piled pressure on Republican lawmakers to move quickly to raise the country's $31.4 trillion debt ceiling or risk throwing the US economy into a recession that would kill thousands of jobs https://t.co/G3OKKVG76F pic.twitter.com/JrvXAJ149t

— Reuters (@Reuters) May 11, 2023

What do the experts say?

The International Monetary Fund (IMF) has emphasized the serious consequences that could arise from this situation for the global economy. JP Morgan CEO Jamie Dimon has taken precautions to prepare for the potential disaster, reported Nasdaq.

US Treasury Secretary Janet Yellen warned that a US default would produce an "economic and financial catastrophe" that would trigger a global economic downturn and risk undermining the country's ability to provide global leadership, reported CNN.

"A default would threaten the gains that we've worked so hard to make over the past few years in our pandemic recovery. And it would spark a global downturn that would set us back much further," Yellen said.