What is the US “debt ceiling” and what happens if it is not raised?

The US government has hit its self-imposed spending limit. Unless that limit is raised, the government will run out of money. Saloni Sardana explains what would happen then.

Somewhat unusually, the US government has a self-imposed legal limit on the amount of money it can borrow to fund itself. This is called the “debt ceiling”. If it looks like the government needs to spend more than this limit, then that must be authorised in Congress. If Congress fails to authorise a new limit, the government must stop spending money. All activity funded by the federal government comes to a sudden halt. 

In less polarised times, a rise would usually be approved with little fuss. But for the last decade or so, the debt ceiling has been used as a political weapon, with opposition politicians happy to use the threat of a government shutdown to further their own aims, score political points, or just cause trouble. 

The House of Representatives – the lower chamber of the US government – has already passed a bill to raise the debt ceiling. But it must now pass a vote in the Senate, where the Democratic Party has 50 of the 100 seats, plus the vice president’s vote. To pass, however, the bill needs 60 votes.

An attempt to pass the bill on Monday failed to get enough votes in the Senate. A second attempt on Tuesday also failed. And Republicans have also blocked a way for the Democrats to raise the ceiling alone. Senate minority leader Mitch McConnell blocked a motion by Chuck Schumer, the majority leader, that would have allowed an increase with a simple majority vote. 

Why is the debt ceiling so important?

The federal government is heavily reliant on debt. More often than not, it spends more than it earns from taxation. To cover the shortfall, the government borrows. Sounds simple. But the US breached that limit on 1 August, prompting the Treasury to take some “extraordinary measures.”

But even those extraordinary measures are not permanent, and at some point the government will run out of money. The Treasury estimates that date to be 18 October because “at that point, we expect the Treasury would be left with very limited resources that would be depleted quickly,” US Treasury secretary Janet Yellen told congressional leaders this week. 

Raising the debt ceiling is important, as it makes it less likely the US will plunge into recession or default on its debt. The world’s largest economy defaulting on its debt would be a terrifying concept that would hit global financial markets hard. Such a default would probably send the dollar tumbling. Spending on many critical programmes would come to a halt. 

What is the latest position?

Senate minority leader Mitch McConnell insists that Republicans will not support raising the limit. This is similar to what happened in 2011 between Republicans and the Obama administration. The spat back then eventually prompted the US’ credit rating to be downgraded for the first time. 

While arguments over debt ceilings are common, it’s a bit more surprising that it is happening this year as the pandemic has meant the US government pouring billions more dollars into the economy than it normally would. US Federal debt is currently at about $28.43trn, higher than the current debt ceiling of $28.4trn.

The Republicans are opposed to raising the ceiling as they believe it will pave the way for Democrats to pass their $3.5trn Build Back Better spending package. 

Can the Democrats still raise the debt ceiling alone? 

Biden can technically still raise the ceiling alone, albeit through drastic means. Democrats could use the budget reconciliation process to foster a majority vote in the Senate. Biden’s $1.9trn stimulus package was passed in this manner earlier this year. 

And according to David Super, Georgetown University’s law professor, the best solution may be to just eliminate the debt ceiling entirely. “The Congressional Budget Act gives Democrats the chance to do a stand-alone reconciliation bill on the debt limit if they want,” he told the Washington Post. 

So, the Democrats could form a reconciliation bill and create another bill that cancels the debt limit. But these options are a last resort for the Biden administration. 

Has the US defaulted before?

The US government has defaulted on its debt before. As Forbes points out, the US defaulted on some Treasury bills in 1979.

The default was temporary though, as the Treasury did eventually pay the investors after a short delay. A default by the US government in current times is almost certainly going to leave much longer lasting damage. 

What effect will a further delay or default have on the markets?

A default by the US government would send shockwaves across the world. 

As Beth Ann Bovino, chief US economist at S&P Global Ratings, points out: “The impact of a default by the US government on its debts would be worse than the collapse of Lehman Brothers in 2008, devastating markets and the economy.”

Such a collapse would also hit the US bond market which until now has been seen as the ultimate safe haven. 

And not even the US Federal Reserve, the world’s most powerful central bank, thinks the economy can weather such a scenario. John Williams, president of the Federal Reserve Bank of New York, said it could lead to an “extreme kind of reaction in markets”. 

And according to Moody’s Analytics, gridlocked discussions regarding the debt ceiling could take six million jobs out of the economy, cause the unemployment rate to climb from 5% to 9% and cause the stockmarket to lose a third of its value. 

If you are an investor, the best thing you can do is to not panic. It is likely that the US government will come to some sort of agreement, albeit with a delay. After all, nobody actually wants the world’s largest economy to default.

Recommended

Share tips of the week – 7 October
Share tips

Share tips of the week – 7 October

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
6 Oct 2022
China’s economy is heading for a sharp slowdown
Chinese economy

China’s economy is heading for a sharp slowdown

With a slowing property market, Covid lockdowns sapping growth and the CSI 300 stock index down by 22% this year, China’s economy is in trouble.
6 Oct 2022
5 of the world's best stocks
Share tips

5 of the world's best stocks

Concentrating on a few highly profitable companies that excel in their fields can reduce the overall risk in your portfolio, says Rupert Hargreaves. H…
6 Oct 2022
The dangers of derivatives as the “Goldilocks era” ends
Investment strategy

The dangers of derivatives as the “Goldilocks era” ends

That this is no longer a benign environment for investors, says Andrew Van Sickle. But – as the recent pension-fund derivatives blow-up shows – not ev…
6 Oct 2022

Most Popular

Should you take a 25% tax-free pension lump sum in instalments?
Pensions

Should you take a 25% tax-free pension lump sum in instalments?

Taking out a 25% tax-free lump sum sounds appealing but it might not be the best way to manage your pension
30 Sep 2022
Markets may have bounced, but this is not the end of the bear market
Stockmarkets

Markets may have bounced, but this is not the end of the bear market

Stocks are back on the rise, commodities and precious metals prices are up – even the pound has rebounded. But none of this is typical of bull markets…
5 Oct 2022
October’s Premium Bonds: how to check if you are a winner
Savings

October’s Premium Bonds: how to check if you are a winner

NS&I has added almost 110,000 more prizes to October’s Premium Bond draw – are you a winner?
4 Oct 2022