On 15th December 2021, the US Senate voted to increase the country’s debt ceiling by US$2.5 trillion in an attempt to prevent the first possible US default. According to the Treasury Secretary Janet Yellen, failure in raising the borrowing limit would’ve led to recession and unemployment throughout the country. However, this situation leads to few questions regarding the purpose, importance and implications behind the debt ceiling.
Simply put, the debt ceiling is the limit to how much debt a country can take on. In the US, the debt ceiling was implemented in 1917 and has been raised countless times since the US regularly comes close to surpassing it. However in 2022, the US debt is at an all-time high (surpassing $30 trillion as on 1st February 2022). Understanding the reasons behind such exorbitant debt and the implications of failing to raise the debt ceiling requires starting from the basics.
The department of Treasury collects taxes and spends it to fund the government, while the Congress decides the amount of taxes and how the money should be spent. However, for a long period of time, the money spent was more than the amount collected leading to deficits. Hence, to meet the budget deficits, the treasury had to take on debt through the process of issuing bonds. The cycle has been going on ever since, just like most other countries. The bonds are held by domestic investors (Americans and American Companies), foreign investors and the US Federal Government itself (as the money for Social Security, Medicare and pensions is kept in the form of bonds).
US debt has increased by 800%, from 1989 to 2021 and constant budget deficits caused by the policies undertaken by the US government are said to be responsible for the rising debt. Entitlement programs such as Social Security and huge defense spending, coupled with lower revenue collection in the form of tax cuts, are some of the major contributing factors.
However, the US has not faced the repercussions of being the most indebted country due to unusually low interest rates and confidence in the bonds as a safe and secure investment. The level of confidence and trust in the US treasury bonds is not enjoyed by any other country in the world. It’s the reputation of the bonds as a safe and risk-free investment that has allowed the country to continue raising debt. As long as people and institutions continue to have confidence in the bonds, the US can keep raising debt.
This is where the debt ceiling comes into play. Since it’s a barrier to how much debt the country can accumulate, the ceiling needs to be raised to ensure the functioning of the country. In case the debt ceiling is not increased and the US hits the ceiling, the treasury cannot issue bonds- which implies that the country will be unable to take on any more debt. The taxes collected will not be sufficient for the required spending, which might make the treasury unable to pay the salaries of federal employees and government programs as the revenue collected would have to be diverted to interest payments on the debt. However, the US treasury would reach a point where it will be unable to pay interest to investors or cash out on social security bonds. The resulting default would have a destructive impact on the country’s financial systems and people would start viewing the treasury bonds as less safe, leading to higher interest rates to compensate for the increased risk. This would lead to a catastrophic situation, a recession with a massive decrease in wages and employment, the effects of which would be felt worldwide.
This might make the debt ceiling seem to be a hindrance which should be repealed through legislation. The debt ceiling could be a useful tool under ideal circumstances, where it’s used to ensure the country doesn’t borrow more than it can and to maintain a check on borrowing. However, the reality is far from ideal, the ceiling fails to serve its purpose as it keeps getting raised and the political back-and-forth over the debt ceiling might make the United States a less desirable place to invest, similar to the debt ceiling crisis of 2011, which resulted in a downgrade in the US’s long term credit rating from AAA to AA+. The current climate of continued political polarization might lead to a further downgrade in the US’s credit rating and would present the world with grave consequences.