Explained: What's The US Debt Ceiling Crisis, How Could World Economy Take A Hit If US Defaults On Debt?

After days of deadlock, the talks on debt ceiling are set to resume on Monday as President Joe Biden will meet Republican leader Kevin McCarthy. 

The United States is currently locked in an unprecedented debt ceiling crisis as the Republican majority of House of Representatives and Biden administration have been unable to come to a common group by now.

For the first time, the United States faces the serious risk of defaulting on its debt, which experts say would not just adversely affected the US economy but would also carry significant pains for the world economy. 

Here we explain what's the debt ceiling, what's the current debt ceiling crisis, and how the US default could affect the world.

What is the US debt ceiling?

The debt ceiling is the amount of money the US government is allowed to borrow to pay the nation's bills.

In the United States, the Congress comprising the House and Senate approves the budget and funds for the Executive branch to run the country. 

The issue of debt ceiling arises from the fact that the United States has been running a fiscal deficit since 2001. Since income of the government is less than the expenditure, the government has to borrow to function. There is a limit to that borrowing which is periodically increased to allow the government to borrow more and continue working. 

If the debt ceiling is not increased or suspended, the government would not be able to borrow and pay its outstanding dues. 

So far, such a situation has happened only once and that too from an accounting error and not a political crisis.

"The US has defaulted on its debt just once before, in 1979. A technical bookkeeping glitch resulted in delayed bond payments, an error that was quickly rectified and only affected a small number of investors," notes CNBC.

US Secretary of Treasury Janet Yellen has said the United States could default in early June if the debt ceiling is not extended.

What is the ongoing debt-ceiling crisis?

So far, the debt-ceiling has been increased periodically to enable the US government to function and prevent the country from defaulting.

However, the Republicans in the House and the Biden administration are currently at an impasse. The plans proposed by each-other are unacceptable to both.

The Republicans passed a bill in the House in April that would increase the debt-ceiling by $1.5 trillion or until March 31, 2024 —whichever comes first— along with a set of conditions that Democrats and Biden administration have so far not accepted. 

While the Republicans argue that measures proposed by them are required for fiscal health of the United States, the Democrats say the Republicans are cutting much-needed welfare measures.

Yahoo Finance reports, "These measures, Republicans say, would impose fiscal discipline on Washington that has been lacking in recent years. Meanwhile, critics say the plan would disproportionately place the responsibility for lowering the deficit on social programs, while skirting major cuts to politically popular programs like the Pentagon and veteran services that McCarthy has said will largely be spared."

The bill passed by Republicans includes more working hours if you get welfare cheques, opening up of more areas for fossil fuel production, and undoing green energy tax credits, among other measures, reports Yahoo Finance. 

Biden earlieer expressed confidence that the United States would not default on its debt and the negotiations are about the nature of budget and not about the fundamental question of default. However, the positions have since hardened.

Biden on Sunday said that Republicans must move off their "extreme positions" and that there would be no agreement to their terms.

He said, "It’s time for Republicans to accept that there is no bipartisan deal to be made solely, solely, on their partisan terms. Now it’s time for the other side to move from their extreme position." 

Impact of possible US default

The result of the US default would be a disaster for the US economy. An estimate by Moody's Analytics says even if the debt limit were breached for no more than a week, the US economy would weaken so much so fast that roughly 1.5 million jobs would be wiped out.

The United States would be hit by a recession and share markets would become very volatile, according to CNBC.

Citing a note by Wells Fargo Economics, CNBC reports that The S&P 500 fell nearly 17 per cent between July 22 and Aug. 8 during the debt-ceiling impasse in 2011, which was "perhaps the closest brush the United States has had" with default.

Zandi and two colleagues at Moody's have concluded that even if the debt limit were breached for no more than a week, the US economy would weaken so much, so fast, as to wipe out roughly 1.5 million jobs.

And if a government default were to last much longer —well into the American summer— the consequences would be far more dire, Zandi and his colleagues found in their analysis: US economic growth would sink, 7.8 million American jobs would vanish, borrowing rates would jump, the unemployment rate would soar from the current 3.4 per cent to 8 per cent and a stock-market plunge would erase USD 10 trillion in household wealth.

A default could shatter the $24 trillion market for Treasury debt, cause financial markets to freeze up and ignite an international crisis.

"A debt default would be a cataclysmic event, with an unpredictable but probably dramatic fallout on US and global financial markets," said Eswar Prasad, Professor of trade policy at Cornell University and senior fellow at the Brookings Institution.

The threat has emerged just as the world economy is contending with a panoply of threats — from surging inflation and interest rates to the ongoing repercussions of Russia's invasion of Ukraine to the tightening grip of authoritarian regimes. On top of all that, many countries have grown skeptical of America's outsize role in global finance.

Effect of US default on world

If the debt crisis roiling Washington were eventually to send the United States crashing into recession, America's economy would hardly sink alone.

The repercussions of a first-ever default on the federal debt would quickly reverberate around the world. 

Orders for Chinese factories that sell electronics to the United States could dry up. Swiss investors who own US Treasurys would suffer losses. Sri Lankan companies could no longer deploy dollars as an alternative to their own dodgy currency.

"No corner of the global economy will be spared" if the US government defaulted and the crisis weren't resolved quickly, said Mark Zandi, chief economist at Moody's Analytics.

Of all the foreign exchange reserves held by the world's central banks, US dollars account for 58 per cent. No. 2 is the euro: 20 per cent. China's yuan makes up under 3 per cent, according to the IMF.

Researchers at the Federal Reserve have calculated that from 1999 to 2019, 96 per cent of trade in the Americas was invoiced in US dollars. So was 74 per cent of trade in Asia. Elsewhere outside of Europe, where the euro dominates, dollars accounted for 79 per cent of trade.

So reliable is America's currency that merchants in some unstable economies demand payment in dollars, instead of their own country's currency. 

Consider Sri Lanka, battered by inflation and a dizzying drop in the local currency. Earlier this year, shippers refused to release 1,000 containers of urgently needed food unless they were paid in dollars. 

The shipments piled up at the docks in Colombo because the importers weren't able to obtain dollars to pay the suppliers.

"Without (dollars), we can't do any transaction," said Nihal Seneviratne, a spokesman for Essential Food Importers and Traders Association. "When we import, we have to use hard currency — mostly the US dollars."

Likewise, many shops and restaurants in Lebanon, where inflation has raged and the currency has plunged, are demanding payment in dollars. In 2000, Ecuador responded to an economic crisis by replacing its own currency, the sucre, with dollars — a process called “dollarisation'' — and has stuck with it.

Even when a crisis originates in the United States, the dollar is invariably the go-to haven for investors. That's what happened in late 2008, when the collapse of the US real estate market toppled hundreds of banks and financial firms, including once-mighty Lehman Brothers: The dollar's value shot up.

"Even though we were the problem — we, the United States — there was still a flight to quality," said Clay Lowery, who oversees research at the Institute of International Finance, a banking trade group. "The dollar is king."

If the United States were to pierce the debt limit without resolving the dispute and the Treasury defaulted on its payments, Zandi suggests that the dollar would once again rise, at least initially, "because of the uncertainty and the fear. Global investors just wouldn't know where to go except to where they always go when there's a crisis and that's to the United States".

But the Treasury market would likely be paralysed. Investors might shift money instead into U.S. money market funds or the bonds of top-flight US corporations.

Eventually, Zandi says, growing doubts would shrink the dollar's value and keep it down.

In a debt-ceiling crisis, Lowery, who was an assistant Treasury secretary during the 2008 crisis, imagines that the United States would continue to make interest payments to bondholders. And it would try to pay its other obligations — to contractors and retirees, for example — in the order that those bills became due and as money became available.

For bills that were due on June 3, for example, the government might pay on June 5. A bit of relief would come around June 15. That's when government revenue would pour in in as many taxpayers make estimated tax payments for the second quarter.

The government would likely be sued by those who weren't getting paid — “anybody who lives off veterans' benefits or Social Security,'' Lowery said. And ratings agencies would likely downgrade US debt, even if the Treasury continued to pay interest to bondholders. 

The dollar, though it remains dominant globally, has lost some ground in recent years as more banks, businesses and investors have turned to the euro and, to a lesser extent, China's yuan. Other countries tend to resent how swings in the dollar's value can hurt their own currencies and economies.

A rising dollar can trigger crises abroad by drawing investment out of other countries and raising their cost of repaying dollar-denominated loans. The United States' eagerness to use the dollar's clout to impose financial sanctions against rivals and adversaries is also viewed uneasily by some other countries.

So far, though, no clear alternatives have emerged. The euro lags far behind the dollar. Even more so does China's yuan; it's hamstrung by Beijing's refusal to let its currency trade freely in global markets.

But the debt ceiling drama is sure to heighten questions about the enormous financial power of the United States and the dollar.

"The global economy is in a pretty fragile place right now," Obstfeld said. "So throwing into that mix a crisis over the creditworthiness of US obligations is incredibly irresponsible."

(With AP inputs)