The debt ceiling debate is nothing new for the US economy, with the limit having been raised 78 times since 1962.
Other than Denmark, the US is the only country to impose a limit on government debt, leading some to wonder why one is needed at all. Supporters feel the limit is necessary to curtail government spending, while critics describe it as little more than a bargaining tool.
Despite Congress agreeing to suspend the debt limit until early 2025, US Government finances have run a deficit since 2002, with outgoings already $1.16 trillion more than revenues in the current fiscal year.
House speaker, Kevin McCarthy, suggested budget cuts are the only option stating “If you had a child and you gave them a credit card, and they kept hitting the limit—you wouldn’t just keep increasing it. You’d first see what are you spending your money on?”
Except, what do you cut when most spending goes to things like Medicare, Social Security, and other programs that protect the country’s most vulnerable people?
Spending cuts and tax hikes are never popular, causing career-conscious politicians to keep kicking the can down the road. However, borrowing comes at a price, and eventually, all debts must be settled.
Why does the US need a debt ceiling?
The US debt ceiling is the amount the US government can borrow to fund its operations and spending obligations. The limit was introduced in 1917 in response to WW1 to encourage fiscal responsibility.
“That’s part of our checks and balances that we have within the US”, says Doug Hooper, Partner at McCracken Alliance. “It does not allow one party, particularly if they had the house, the senate and the presidency, to make a spending decision [unilaterally].”
However, failure to negotiate terms when it comes to the debt limit runs the risk that the US government could default on its payments. Despite this risk, many Americans are not in favour of removing it.
“I think there’s a big risk that spending could get out of control”, says Hooper who suggests the amount of lobbying present in US politics would lead to the misuse of funds.
“Everybody would want their two cents”, he adds, and there would be no means to create roadblocks to this.
While nobody wants the US government to default on its payments, continuously adjusting the debt ceiling is not a sustainable financial model either. According to the Congressional Budget Office (CBO) the Federal Debt is at its highest level since post-war 1950s, and based on current outgoings is expected to climb to 150% of GDP by 2047.
If debt keeps rising at this level, interest rate repayments will be the third largest expenditure by the US government by 2028.
With financial markets being notoriously volatile, the US does not even have to default for there to be an impact. Recently investors started to demand higher interest rates on Treasury bonds that would be maturing in June 2023 to compensate for the heightened default risk.
“While we can finance a lot of the US obligations through foreign investors, I think if risk goes up, they may say it’s not worth investing in us”, says Hooper.
As Robert Francis, who is co-head of Americas Sovereigns at Fitch Ratings, says “repeated political standoffs around the debt-limit and last-minute suspensions before the x-date (when the Treasury’s cash position and extraordinary measures are exhausted) lowers confidence in governance on fiscal and debt matters”.
Following recent events Fitch downgraded the US economy to double-A, which signals to investors that it is higher risk.
Why controlling the US debt matters
While Japan has the highest national debt compared to its GDP, in terms of total money owed, the US has the highest debt overall at almost triple that of Japan. There is no nation in the world without some degree of debt, which is not necessarily a bad thing, so what makes the US debt so problematic?
The US is the world’s largest economy and has a huge influence on the strength of the global economy. “[USD] is the world’s preeminent reserve currency, which gives the [US] government unparalleled financing flexibility”, says Francis.
Currently 60% of foreign exchange reserves are held in USD, however that number has been decreasing since the turn of the century.
“There has been a steady deterioration in governance over the last 15 years, with increased political polarisation … repeated brinkmanship over the debt limit and failure to tackle fiscal challenges from growing mandatory spending has led to rising fiscal deficits and debt burden”, adds Francis.
As confidence falls in the US economy, investments become more risky and interest rates go up, “just take interest rates from a couple years ago, when treasuries were 1–2% … then paying the interest on that debt was not as big of a deal”, says Hooper.
“But now that the treasuries are 4–5% that takes a bigger chunk out of the annual budget”.
The unfortunate thing is that most US spending is well-intended.
“I think the US is fairly generous, both to Americans and outside. So we tend to overspend in many cases. And I think currently with COVID, etc … the US went crazy in terms of trying to prop up the economy … help other countries”, adds Hooper. However, that doesn’t change the fact that borrowing is still expensive.
Instead of focusing on reducing the national debt, the US government continuously petitions to raise the limit to avoid being held accountable for the money it’s spending. Nobody wants to do the hard thing and tighten the purse strings, so they keep borrowing, and pass the buck onto the next generation of Americans.
What happens now the limit is suspended
As of June 3, 2023 President Biden signed into law a bill that would suspend the debt ceiling until 2025, but not without opposition.
“In exchange for two-year caps on non-military discretionary spending, the broadening of work requirements for some government support programs, and a rescinding of some unspent Covid related funds, among other provisions,” have been requested, says Francis.
“The agreement provides an estimated saving of $1.5 trillion over the next decade, according to the CBO,” he says, which should help the US to significantly close the deficit, provided those concessions remain in place.
Unfortunately, this suspension will only see the United States through its next election, after which who knows what will happen.
If the US government cannot get control over its spending, then it is likely the financial conditions will continue to worsen and have the potential to affect businesses through increasing interest rates or taxation policy changes.
It is imperative that CFOs, and other finance professionals, remain vigilant and prepare for the worst case scenario; no matter how unlikely it seems.
As Hooper says, this is very much a bipartisan issue that affects not only the entire United States, but has the potential to cause economic ructions globally.
To read part 2 of this article series, please click here.
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