The currents of the world economic and financial system seem to ebb and flow, with some themes hogging the headlines far more often than others. At the start of the year, the buzzword was whether major Central Banks had reached the end of their hike cycle, then it was the boat in Simonstown and load shedding and the potential fallout from that, and now the main headline hog is whether the US will raise its debt ceiling in time.
The question can be asked – what is a debt ceiling, and why is it important?
The easiest way to describe a debt ceiling is to think of it as a household, where there is a cap on the amount of money a household can borrow in order to fulfil its needs. While not the best financial prudence ever, some households need the debt to make ends meet. America is that household, and now we have seen that, in order for them to meet its obligations and not run out of money, they need the debt ceiling lifted. With a higher debt ceiling, it will allow the US to borrow more money to cover its bases.
The debt ceiling is the limit placed by Congress on the amount of debt the government can accrue. In order to pay its bills to those it borrowed from and fork out money for everything from Medicare benefits to military salaries, the government needs more money, and the debt ceiling has to be raised. At the moment, the US finds itself in a quandary as they have hit the debt ceiling of $ 31 trillion in January already, and as Secretary of the Treasury, Janey Yellen stated, a bunch of extraordinary measures had to be done behind the scenes to avoid a default. However, the barrel is starting to run empty as we approach June, and that could mean a default is at hand and the US won’t be able to pay its bills, whether it is bond coupons, salaries, state benefits – the list goes on.
US running out of cash fast
What happens if the US defaults?
The simple answer is, no one knows the exact extent from a default, but there are some certainties that will happen. The obvious answer is that a safe bet like the US treasuries will not look like a safe bet, and this will lead to global effects on economies. The US Treasury website warns that a default on the debt “would precipitate another financial crisis and threaten the jobs and savings of everyday Americans.”
Another effect will be a recession, as households would have less cash on hand to pump into the US economy, and this will have spillover effects into the world economy. Given the fact that the interest rate hiking cycle is not fully through the market, this could be a double whammy for the world economy, and job losses will become the norm.
With the US defaulting, it could bring a wave of higher borrowing costs in the US, as the once trusty financial system and the economy will lose some of its credibility. Borrowing costs would rise for American consumers since rates on mortgages, credit cards, car loans and other types of consumer debt are linked to movements in the US Treasury market. Businesses would also pay higher interest rates on their loans.
A further fallout will be that credit markets will freeze and stock markets will nosedive as investors will move out of riskier assets.
These are only a small indication of what could happen should there be a default, but the effect worldwide might be much larger.
Also read our article, “Is there any collateral damage from the US debt ceiling being lifted?“