The market is glued to the debt ceiling talks with the media reporting about it every day. Why? Because if the US failed to raise the ceiling in time and defaulted on its debts, that would have a far-reaching impact globally. So far, the talks went back and forth between getting nowhere and inching forward as the clock ticks closer to the deadline. According to the US Treasury Secretary, Janet Yellen, the US will start defaulting on its debts in early June if the debt ceiling is not raised by 1 June 2023.
What is this debt ceiling talks all about?
The US debt ceiling was introduced in 1917 to make the government more fiscally prudent and responsible. It sets a limit on how much the government can borrow through its issuance of bonds. The intention was good but its effectiveness was debatable. Because when it comes to the crunch between defaulting and raising the debt ceiling. The no-brainer or inevitable choice for politicians who don’t want to be known as someone who collapse the US economy is always the latter. But that doesn’t prevent politicians from using the debt ceiling as a means to further their own agenda. This leads to showdowns like this one where conservative Republicans pushed for fiscal cuts and prudence as "conditions" to pass the debt ceiling. While there are some really close calls, at the end of all these, the debt ceilings are always raised. Since 1941 till now, the debt ceiling is raised over 100 times from $49 billion to more than $31 trillion today.
Have the US ever defaulted on its debts?
The US has never defaulted over its failure to raise the debt ceiling. That would have been their official line. But it has defaulted for other reasons though if you take default to mean not paying on time no matter what is the cause of that. The most recent one happened in 1979 when they failed to redeem maturing Treasury bills worth $122 million in time. They attributed this to technical glitches and operational issues and all payments were made in 3 weeks. Even though it was only a short technical default and the amount involved represented only 0.01% of the total $830 billion debt issued then, the aftershock was lasting and significant. The yields of Treasury Bills jumped up 0.6% and this increase was embedded for years to come.
What would happen if the US really defaulted on its debt?
That would be disastrous at least in the short term. This would be unprecedented. It represents a major failure of the political system. It will not just be a simple case of not being able to repay debt obligations. Because if they run out of funds, then the government will have trouble financing their daily operations, paying businesses for their service, sustaining their medical care, writing social security checks, building roads, maintaining schools, etc. There will be major disruptions and many people could find themselves out of work suddenly even if it is just temporary.
You will see market volatility surge and investor confidence sinks as rates jump. This will drive up the costs of borrowing for all. Unlike major crises where you will see a flight to quality which leads to a rise in the value of bonds, you may not see this happening in the short term. Because this time around, the faith and credibility of the US government are in question. So Treasuries will likely be hit hard as it gets repriced. The already vulnerable banking system will face greater stress. This will also trigger margin calls and major selling and deleveraging as Treasuries are widely used as collateral against borrowings. In the short term, there won't be many places to hide other than perhaps cash equivalents and gold. You can hedge the portfolio. However, note that it will come with a cost.
Will this time be any different? I would like to believe that no sane politician will risk career suicide and have themselves labeled as someone who crash the US and global economy. As with the past over 100 times, I think the debt ceiling will be raised and this impasse will eventually resolve even if it is at the eleventh hour. Because the pain to both political parties far outweighs any gains they could possibly get from allowing the US to default. It would really be very unnecessary and stupid for that to happen through a self-created mess and then make everyone else in the world pay for their mistakes.
Unsurprisingly, the US Senate and House passed the bill not too long after this post was written to suspend the debt ceiling just a few days before they will run out of funds.
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