A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK.
Levels of US public sector debt have exploded in the last 15 years. The financial crisis and the pandemic have lifted the ratio of US public debt to GDP from about 40% in 2007 to just under 100%. Fighting the financial crisis and Covid have had a similar effect on US debt levels as fighting the second world war. Whereas public spending and debt levels fell sharply after 1945, spending on health and welfare will keep debt rising over the coming years. By 2023 the Congressional Budget Office estimates that US debt will be equivalent to 118% of GDP, far above the wartime peak, and a threefold rise in 28 years.
In the US, unlike most western countries, the government cannot borrow whatever it needs to fund its commitments. Since 1917 the US government has needed Congressional approval to increase borrowing or, in the jargon, raise the debt ceiling. In the last 106 years the ceiling has been raised more than 100 times, generally without significant political opposition. Rising debt levels, and more polarised US politics, have changed that.
In the summer of 2011, the opposition of a Republican-controlled House to raising the debt ceiling forced the Obama administration to close government departments and furlough employees without pay. Panic hit financial markets, with US equities dropping by 17% in late July and early August. Consumer and business confidence dropped as S&P downgraded America’s credit rating from AAA to AA.
During Donald Trump’s presidency the government closed for almost five weeks, its longest ever shutdown, as Democrats in Congress resisted extra borrowing to fund the construction of a border wall with Mexico.
On both occasions deals were done, but not without disruption and market uncertainty. The ultimate fear for markets is of there being no agreement with the government being unable to pay interest on existing debt. A US debt default would be a major financial shock, hitting the value of US bonds and the dollar, two anchor points for global financial markets. It is the stuff of central bankers’ nightmares.
Such an outcome is a low probability event. But further battles over the debt ceiling are inevitable, with the next one likely this summer. The Bipartisan Policy Center estimates the US will reach its statutory debt limit between July and September. Unless Congress agrees to raise the ceiling, the Federal government will run out of money.
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The Republican-led House is narrowly divided with a group of right-wing Republicans holding significant power, something that was seen during the torturous process to elect a new House speaker, Kevin McCarthy, earlier this year. In dealing with the debt issue McCarthy faces an acute dilemma. Raising the debt ceiling requires the agreement of Democratic-controlled Senate and the President. If McCarthy makes a deal the Republican rebels dislike, they could unseat him. If he fails to strike a deal, the US faces shutdowns, furloughing Federal workers and, just possibly, default.
A recent report from investment research firm MSCI noted that trading in credit default swaps which offer protection against a US default have risen sharply. The implied probability of a US default based on CDS pricing has, according to MSCI, roughly tripled since the start of the year, testifying to growing investor worries about the debt ceiling.
The pattern of past debt battles is that the Federal government limps on by closing departments and furloughing staff and a deal is eventually made. But US politics is more fractious than it was, and such an outcome is not guaranteed. In recent years events have had a worrying tendency not to conform to expectations. If you follow business, economics or financial markets, it’s a good reason to ensure you have decent Wi-Fi on holiday this summer.
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