US Treasury Secretary Janet Yellen on January 10, 2023 in Washington.
Kevin Deitch | News from Getty Images | Getty Images
The US may be about to hit its debt ceiling.
Treasury Secretary Janet Yellen said last week that the US would likely reach the ceiling on Thursday. Absent steps taken by Congress, the event could “cause irreparable harm to the U.S. economy, the livelihoods of all Americans and global financial stability,” she wrote in a letter to incoming House Speaker Kevin McCarthy, R-Calif.
Here’s what the debt ceiling is and what makes it so important to consumers.
What is the debt ceiling?
The debt ceiling is the amount of money the US Treasury is authorized to borrow to pay its bills.
These obligations include Social Security and Medicare benefits, tax refunds, military pay and interest payments on outstanding national debt.
The current cap is about $31.4 trillion. Once hit, the US can’t increase the amount of its outstanding debt – and paying the bills becomes harder.
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“Not unlike many households, the government relies on debt to finance its obligations,” said Mark Hamrick, senior economic analyst at Bankrate. “And like many households, it doesn’t have enough income to finance its expenses.”
The debt ceiling would not be a problem if US revenues—i.e. tax revenues – exceed their costs. But the U.S. hasn’t had an annual surplus since 2001 — and has borrowed to finance government operations every year since then, according to the White House Council of Economic Advisers.
Why is the debt ceiling a problem right now?
Although the US is expected to reach its $31.4 trillion borrowing limit on Thursday, that in itself is not the main problem.
The Treasury Department has temporary options to pay bills: It can use cash or spend all incoming revenue, such as those during the tax season that begins Jan. 23.
It can also use so-called “emergency measures” that free up money in the short term. The Treasury Department will begin using such measures this month, Yellen said. These include buybacks or suspensions of investments in certain federal retirement and disability funds. Funds will be collected later.
These maneuvers are intended to avert a potential disaster: a default.
A default would occur if the U.S. runs out of money to meet all of its financial obligations on time — such as missing a payment to investors who hold U.S. government bonds. The US issues bonds to raise money to finance its operations.
The U.S. has defaulted on its debt only once before, in 1979. An accounting technical error led to delayed bond payments, an error that was quickly rectified and affected only a small share of investors, the Treasury Department said.
However, the US has never “intentionally” defaulted on its debt, the CEA economists said. That outcome is one that Yellen warned would cause “irreparable harm.” The extent of the negative shock waves is unknown because it hasn’t happened before, economists said.
“The implications are serious,” said Mark Zandi, chief economist at Moody’s Analytics.
“This will create chaos in the financial markets and completely undermine the economy,” he added. “The economy will go into a severe recession.
Fallout: Frozen benefits, recession, more expensive loans
It is difficult to determine an exact date of default due to the volatility of government payments and revenues. But that is unlikely to happen before early June, Yellen said.
In the meantime, Congress can raise or temporarily suspend the debt ceiling to prevent a debt ceiling crisis — something lawmakers have done many times in the past. But the political impasse calls into question their ability or willingness to do so this time.
[A default] would wreak havoc on the financial markets and completely undermine the economy.
Mark Zandi
chief economist at Moody’s Analytics
If the US were to default, it would send several negative shock waves through the US and global economies.
Here are some of the ways it could affect consumers and investors:
1. Freeze federal aid
Tens of millions of American households may not receive certain federal benefits — such as Social Security, Medicare and Medicaid, as well as federal food, veterans and housing assistance — on time or at all, the CEA said. Government functions such as national defense could be affected if, for example, the pay of active-duty military personnel is frozen.
2. Recession with job cuts
Affected households will have less cash on hand to pour into the U.S. economy — and a recession “seems inevitable” under the circumstances, Hamrick said. A recession will be accompanied by thousands of job losses and higher unemployment.
3. Higher borrowing costs
Investors typically look to US Treasuries and the US dollar as safe havens. Bondholders are confident that the US will pay their money back with interest on time.
“In the U.S. financial system, it’s inviolable that U.S. Treasury debt is risk-free,” Zandi said.
If that’s no longer the case, rating agencies are likely to downgrade the U.S.’s sterling credit rating and people will demand much higher interest rates on government bonds to compensate for the added risk, Zandi said.
Borrowing costs will rise for US consumers as interest rates on mortgages, credit cards, car loans and other types of consumer debt are linked to movements in the US Treasury market. Businesses will also pay higher interest on their loans.
4. Extreme stock market volatility
Of course, this assumes that businesses and consumers can get credit. There could also be a “severe” financial crisis if the U.S. government is unable to issue additional Treasuries, which are a major component of the financial system, Hamrick said.
“A default would send shockwaves through global financial markets and likely lead to a freeze in credit markets around the world and a plunge in stock markets,” the CEA said.
Even the threat of bankruptcy during the 2011 debt ceiling “crisis” caused Standard & Poor’s (now known as S&P Global Ratings) to downgrade the US credit rating and generated significant market volatility. Mortgage rates rose 0.7 to 0.8 percentage points for two months and then slowly fell, the CEA said.
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