Another debt ceiling crisis is here, complete with partisan finger-wagging and handwringing newscasters. If Democrats and Republicans cannot overcome their differences on spending, the federal government will run out of money in early June, which could result in a sovereign debt default. Although an agreement has been between the two parties’ leadership, now comes the hard part: selling the deal to the rank and file in Congress and the Senate. Hardliners in both parties could complicate matters. Will the center stand?
Although the United States has never had a sovereign debt default in its history, Washington’s current political class has opened the door to such possibility. Sadly, the American public is jaded: they have seen this show before. The expectation from many market participants is that the parties will posture until the last minute or a little over the time when the financial buzzer goes off, but then reach an agreement. Both sides will then declare victory, arguing that the other side blinked first. The problem with this game of chicken is neither side can stand down on their respective positions (due to internal party politics) or let a default happen.
We can expect an agreement in the last hour possible, but there is a rising risk that the political class miscalculates and plunges the United States into a debt default, which could have a knock-on effect on the dollar and the U.S. role in the world.
What Is the Debt Ceiling?
According to the U.S. Treasury Department, the debt limit, or debt ceiling as it is more commonly known, is “the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments.” Historically, the debt ceiling has been around since 1917, being modified by the Public Debt Acts passed in 1939 and 1941.
At present, the debt ceiling is currently at $31.46 trillion; we are roughly there now.
Congress has always acted when called upon to raise the debt limit since 1960, having acted seventy-eight separate times to permanently raise, temporarily extend, or revise the definition of the debt limit. This happened forty-nine times under Republican presidents and twenty-nine times under Democratic presidents.
Failure to increase the federal debt limit will result in multiple consequences—a sovereign debt default, financial crisis, economic downturn (with global repercussions), job losses, shutdowns of parts of the government, a possible suspension of Medicare payments, and, theoretically, rating downgrades of the U.S. AAA/AA+ sovereign debt rating. The issue gets complicated very quickly, depending on how long a default would last and which obligations are not met. Indeed, U.S. treasury secretary Janet Yellen has repeatedly warned that if the debt ceiling is not raised soon, there will be “hard choices to make about what bills go unpaid.”
One of the big worries related to a potential default is that such an event would give further momentum to the dethronement of the U.S. dollar as the world’s major reserve currency. Although this issue is hard to translate into the day-to-day living of Americans, it matters. China, Russia, South Africa, and several other countries have already begun to conduct part of their trade in other currencies to escape the U.S. government’s potential weaponization of its national currency, which has been evident in economic sanctions leveled against Russia. For anyone watching, China has been working hard to de-dollarize, reducing its exposure to Treasury Securities from over $1 trillion in 2022 to $859 billion in January 2023 (and it is expected to drop lower).
While a rapid shift away from the U.S. dollar is not likely in the short term, the trend is not Washington’s friend. A sovereign default caused by a lack of political will as opposed to capacity to pay would certainly fuel the momentum to dollar dethronement. With that would come the end of Washington’s ability to endlessly print money in the form of U.S. Treasuries and other securities.
The decline of the U.S. dollar would have consequences for the American political classes’ voracious appetite for ever-greater public spending. But, say the pundits, that will never happen, as Washington’s debt ceiling politics are a show that will go on forever—especially as deficits do not matter!
However, deficits will not matter until they do; the continued stripping away of U.S. comparative advantages—stable democratic politics, prudent economic policy, a general consensus over economic policy, and manageable debt—all have a cumulative impact.
The problem facing the United States is not just the debt ceiling. Indeed, the debt ceiling crisis itself is a symptom of something far more problematic: a tired political system limping along, quite possibly broken. The critical middle ground where the ugly sausage-like making of laws takes place has been radically shrunk. Compromise is a dirty word, especially when it comes to budgets and deficits. Political virtue is now defined more by ideological purity, something upheld by the extreme right in the Republican Party and the far-left progressives in the Democratic Party. Neither extreme courts pragmatism; rather, they embrace vilification of the other, victimhood, and a winner-takes-all approach.
The Politics of No Economic Pain
The massive amounts of federal spending and borrowing since the 2008–09 financial crisis have been geared to make certain that even when there is an economic slowdown, spending goes to help buffer the depth of the downturn. This goes for the middle and working class as well as big business and the financial sector. The extended period of low-interest rates was taken by many as cheap money. This helped Wall Street hit record highs, kept zombie corporations lurching along, and boosted average savings through the coronavirus pandemic.
One result of this is that there is no traditional business cycle of expansion, peak, contraction, and trough—yet. One sign of this is that bankruptcies remained at historically low levels from 2009 through 2020. According to S&P Global, it is only in 2023 that corporate bankruptcies have been on the rise, with the first two months registering the highest total for any comparable period since 2011. Indeed, the response to the latest round of bank failures was to raise the FDIC ceiling on deposit losses.
Even the Federal Reserve’s push to cut inflation is running into the politics of no pain. While the central bank has hiked interest rates, the Biden administration has launched two major spending programs, the CHIPS and Science Act, which provides roughly $280 billion in new funding to boost domestic research and manufacturing of semiconductors, and the $369 billion Inflation Reduction Act, which invests in domestic non-fossil fuel energy production while promoting so-called clean energy. If successful, the two programs will greatly reduce U.S. dependence on China, make major strides towards zero carbon targets, and completely transform the U.S. economy. At the same time, specific interest groups are disproportionately benefiting, including the tech sector, unions, and the auto industry (all of which have well-lubricated lobbying machines working overtime in Washington).
What provides hope in the current crisis is that moderates in both parties want a deal. As it stands, the agreement entails a two-year appropriations deal, a two-year extension of the debt limit (pushing the issue back past the 2024 election); work requirements to receive federal aid under the Supplemental Nutrition Assistance Program, commonly known as food stamps, for people up to fifty-four years of age, with exceptions for the homeless and veterans. Medicaid will not be affected. Although Republican and Democratic hardliners are likely to oppose the deal and complicate its passage, the likelihood is that moderates from both parties will be enough to pus the deal through the House and Senate. If not…
Looking ahead, the debt ceiling crisis will probably be resolved before the federal government runs out of money or shortly thereafter. However, the wounded nature of U.S. politics leaves the door open to a further erosion in U.S. economic policymaking that erodes King Dollar’s international role and undermines the United States’ global leadership. Ongoing threats of politically-induced default do little to instill confidence in a currency. Although stated in the late nineteenth century, German chancellor Otto von Bismarck gave sage advice to those who wish to lead, “Fools learn from experience. I prefer to learn from the experience of others.” There are plenty of examples of countries where economic and political consensus broke down, with interest groups fragmenting the national good; but it could be that Washington prefers not to listen to such advice. A lot is riding on making the right choice.
Dr. Scott B. MacDonald is the Chief Economist for Smith’s Research & Gradings, a Fellow with the Caribbean Policy Consortium, and a Research fellow with Global Americans. Prior to those positions, he worked for the Office of the Comptroller of the Currency, Credit Suisse, Donaldson, Lufkin and Jenrette, KWR International, and Mitsubishi Corporation. His most recent book is The New Cold War, China and the Caribbean (Palgrave Macmillan 2022).