You will have come across the term “debt ceiling” in recent news https://www.bbc.co.uk/news/business-65522169. So what is it all about, and why does it matter? Although it is a concept in U.S. domestic politics, its repercussions could be felt across the globe.

Understanding the Debt Ceiling

The debt ceiling is the legal cap that the U.S. Congress sets on the amount that the U.S. Treasury can borrow. It does not authorize any new spending or taxes; it simply allows the government to pay for what Congress has already approved. The debt ceiling was introduced in 1917; before then, Congress tended to authorize borrowing only for specific purposes, which is not really helpful in complex economic systems. But when raising money to support America’s entry into the First World War, Congress granted the Treasury more flexibility, eventually setting a comprehensive debt ceiling in 1935.

History and Recent Developments

For a long time, setting this ceiling was a pro forma exercise. Since 1960, it has been raised around 80 times, irrespective of who was sitting in the White House. Even during Donald Trump’s presidency, a bipartisan congressional majority raised the ceiling three times, and Democrats agreed to a two-year suspension of the ceiling as part of a budget agreement in 2019, which has since expired.The current ceiling for gross debt is USD 31.4 trillion (or 117% of GDP), and America is getting closer to it. On May 1st, Janet Yellen, the Treasury Secretary, warned that the government was set to exhaust its cash reserves and run out of budgetary gimmicks as soon as June 1st.

Potential Consequences of Not Raising the Debt Ceiling

Once the Treasury cannot borrow any more money, it has to reduce or even stop (some) spending or default on its payment obligations. Even if you are in favor of reducing state spending, an abrupt reduction will be tricky. Imagine the government having to choose between paying pensioners, servicing its existing debt, or spending on healthcare.Eventually, this could lead to a government shutdown in the U.S. In the 80s and 90s, these shutdowns lasted for a couple of days (or even just hours) and were almost part of political folklore. However, there were some shutdowns that lasted longer and had more substantial effects. The last shutdown during the Trump years in 2018/19 lasted for 35 days. That led to nine executive departments with approximately 800,000 staff members having to shut down partially or even in full.This affected roughly a quarter of all government activities and caused employees to be furloughed or required to work without being paid. The Congressional Budget Office estimated that this shutdown cost the U.S. economy at least USD 11 billion, not taking into account (far higher) indirect costs, which are difficult to quantify. A significant reduction in public spending (even if it is just temporary) could trigger a recession.

Global Impact of the U.S. Debt Ceiling

Does that matter to us in and around the Wharf? Can’t we just let the Americans continue with their political gambits? Sadly not. In short, the cost of finance will go up at a time when interest rates are already quite high (and should probably be even higher in the UK to combat inflation).The worst case would be defaulting (i.e., not paying interest) on Treasury securities. Like it or not, the dollar is the world’s reserve currency, and much of the global financial system is built on the assumption that Treasuries are risk-free. If that assumption does not hold true anymore, lenders will ask for higher risk premiums—i.e., higher interest rates—to account for this risk.The last time America flirted with a default, Standard & Poor’s stripped America of its AAA rating. This, in turn, will raise interest rates as it is now official that the U.S. is seen as a higher risk. For the UK, this could mean even higher interest rates (or rents, as your landlord will pass his higher mortgage rates on to you), which in turn means less spending (more of your disposable income going towards mortgage payments rather than buying other goods and services) and/or increased prices (if you are paying more for rent, you will ask for a salary increase to make ends meet). You can see how the spiral could go on and on.

Further Implications Even If Disaster Is Averted

Even if nothing happens and Congress manages to raise the debt ceiling before a shutdown or even a default, its toying with disaster is a stark warning about the deterioration of America’s fiscal health and the difficulty of recovering it. And this could well spread: investors might also doubt the safety of other (almost) risk-free assets, mostly bonds issued by governments or big corporations, and demand to be compensated for (perceived) higher risks, so the cost of borrowing would increase across the board. You might remember this from the sovereign debt crises in the early 2010s.

Political Dynamics in the US

Given the highly polarised nature of U.S. politics, a compromise by the remaining sensible Republican members of Congress might be described as treason by the (small but extremely vocal) MAGA wing in the run-up to the presidential elections next year. It would also offer them the opportunity to paint Democrats as the party of irresponsible spending (not acknowledging the fact that raising the debt limit simply lets the government pay bills racked up under previous administrations). Democrats, in turn, would like to drive a wedge between the factions of the Republicans and/or paint them as not fit for office, enforcing a shutdown for ideological reasons while the Democrats were reaching out across the aisle for a compromise in the interest of the country (who are the real patriots now?).

Possible Scenarios

My guess is that there will be a last-minute compromise, maybe even a short shutdown, so that Republicans can save face by proving that they can play hard. After all, only a handful of Republicans need to vote for a compromise to pass. A (very) short shutdown can be used to clear holidays or overtime, so might grab headlines but would not be overly catastrophic. However, with enough turmoil in the markets at the moment, an early compromise would let us all sleep a lot better.What is the likeliest outcome in your opinion?