In the US, Republicans and Democrats are once again battling over the US debt ceiling, which is a statutory limit on how much the government can borrow to pay its bills. Congress suspended the debt ceiling in 2019 for two years under the Trump administration which period expired at the end of July. Since then, the US Treasury Department has taken emergency measures that allowed it to keep borrowing without an increase in the limit.

Treasury Secretary Janet Yellen has warned that any extraordinary measures to postpone the debt limit are likely to run out by mid-October and that if the US doesn’t allow more borrowing, it faces “catastrophe”. In practical terms, this translates into two possible scenarios – the government would either have to implement drastic spending cuts across-the-board or face the prospect of an unprecedented default.

Currently the US government debt is just shy of $28.5 trillion and is expected to reach 102% of GDP by the end of 2021. Around a quarter of this money is held by the government itself through federal agencies, including the Social Security Trust Fund which is by far the biggest holder, while around $5 trillion is held by the Federal Reserve. The rest is public debt. As of May 2021, foreign countries, companies and individuals owned $7.5 trillion of US government debt. Japan and China are the largest holders, with $1 trillion each. The balance is owed to US citizens and businesses, as well as state and local governments.

The debt ceiling came out of the need to accrue more debt during the world wars of the 20th century, prior to which Congress had to specifically approve borrowing for each purpose. However, Congress did not want to write a blank check, so it originally limited borrowing to $11.5 billion and required legislation for any increase. Since then, the limit has been increased dozens of times and suspended on several occassions.

Unless a deal is reached to suspend or raise the debt limit, the US will be in danger of defaulting on its debt. There are some steps the Treasury has already taken to forestall a default, including drawing on saved cash and other emergency measures. But those extraordinary measures are expected to be exhausted by sometime in October.

If all of Treasury’s cash balances are drawn and extraordinary measures have been exhausted, the Treasury would be at the limit of the debt ceiling. Such an outcome has not occurred in the modern era, and it remains uncertain as to exactly what develoments would transpire next.

However, if Congress still does not raise the debt ceiling, the US government would have to operate on a cash-flow basis, meaning that outflows would have to be funded by inflows. Operating in this manner would require prioritisation of payments, which could have several negative implications.

For one, this prioritisation place some counterparties in a subordinate position, which could spook the markets. Also, the rating agencies would most likely place the sovereign rating of the United States under review and would potentially lower the rating if a debt-ceiling increase was not enacted. That could significantly increase the cost of borrowing at the national level.

At the moment, Republicans are determined to exempt themselves of any responsibility for raising the debt limit at a time when Democrats are seeking to significantly expand federal spending. By forcing Democrats to pass an increase, or more likely, a new suspension, without their help, they can try to assign the blame for increasing the debt to the majority party. This kind of behaviour is entirely consistent with congressional practice over the better part of the last century. As long as Democrats are willing to pass a debt limit suspension on their own, the chance of a real crisis is still very low.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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