The United States is facing the prospect of defaulting on trillions of dollars worth of loans, unless the Republicans and Democrats strike a deal to legally allow the US Department of Treasury to incur more debt, which would allow it to pay its bills.
US Treasury officials say that, unless a deal is reached, the US risks running out of money to pay its debts as soon as June 1, and this could trigger a recession, sparking fears of a global economic and financial crisis.
Here’s what it means, where current negotiations stand, and how it could affect Australia.
What’s happened?
To understand the current situation, we need to go back to basics about how the US government’s finances work.
Like all governments, the US government collects money from taxes, but it also has to spend money to fund key services and keep the economy ticking over — but there is a limit on how much they can spend, and how much they can tax.
To make up the difference, the US government has to borrow money to meet its spending commitments, and the more they borrow, the more debt they incur.
Given the sheer size of the US economy, that adds up to hundreds of billions of dollars — and the Treasury department is limited in how much money it is allowed to borrow by Congress.
Debts also need to be paid back with interest, meaning the amount of money the US needs to pay back increases, and Treasury also borrows money to meet those repayments.
That limit is known as the debt ceiling, and the US hit that ceiling on January 19 this year.
Now the US government wants that limit increased, so it is able to make its repayments and obligations but, to do that, it needs to be legislated and approved by the Congress, that is, the House of Representatives and the Senate.
The problem is that the House of Representatives is controlled by the Republican party, and they are refusing to increase the debt limit without commitments from the Democrats to also reduce spending.
So far, that has resulted in a political stalemate, while the US edges closer to running out of money to pay its debts on time.
How much money are we talking about?
The current US debt ceiling is a staggering $US31.4 trillion dollars ($46.8 trillion).
It’s hard to fathom just how much money that is but, for some perspective, it’s more than the entire value of the US economy, which is roughly $US23.3 trillion, according to the World Bank.
Comparatively, Australia’s total gross domestic product is $US1.6 trillion ($2.4 trillion), while its gross debt sits at $923 billion, according to the federal budget.
That means the US debt ceiling is around 20 times larger than the Australian economy.
It’s also not unusual for countries to have a higher amount of debt than their total GDP — in Japan for example, it has a debt limit that is double the size of its economy.
However, in the US, the issue isn’t about whether the amount of debt is good or bad.
“The issue is that they have a hard legislated limit on how much debt the federal government in the United States can hold,” said Ben Picton, a senior economist at Rabobank.
“This has been a problem in the past, and what’s happened … is that Republicans and Democrats in Congress essentially come to an agreement to raise the debt ceiling every time.
“But, this time, we’re running much, much closer to the deadline than what we have before.”
What’s the current state of play?
Without raising the debt ceiling, treasury officials estimate that the US will reach X-date (an economic term that translates to the day it’s unable to pay its bills) by June 1.
Treasury secretary Janet Yellen warned that, not raising the debt limit could spark a “constitutional crisis” and would result in “economic and financial catastrophe” for the US and for global economies.
Congress was urged to take action by Ms Yellen in a letter on Monday, writing that the longer it waits, the more harm is being done.
“Waiting until the last minute to suspend, or increase, the debt limit can cause serious harm to business and consumer confidence, raise short-term borrowing costs for taxpayers, and negatively impact the credit rating of the United States,” she wrote.
“If Congress fails to increase the debt limit, it would cause severe hardship to American families, harm our global leadership position, and raise questions about our ability to defend our national security interests.”
Negotiations are underway in the US Capitol about increasing the debt ceiling, but the House of Representatives and the White House disagree with how to move forward.
Generally speaking, Democrats believe an increase to the debt ceiling is non-negotiable and an obligation of Congress, but Republicans are adamant they will not agree to raise the limit unless the Democrats also agree to spending caps, which the White House hasn’t ruled out.
President Joe Biden and Republican House of Representatives Speaker Kevin McCarthy met to discuss debt ceiling negotiations on Tuesday, local time, ahead of Mr Biden’s travels to Japan for a meeting of the G7.
He was then expected to travel to Papua New Guinea and Australia but, on Wednesday, postponed those legs of his visit due to the debt ceiling crisis.
Speaking after the meeting in Washington, Mr McCarthy said it was likely a deal would be negotiated.
“We set the stage to carry on further conversations. We only have really 15 days to go. We’ve got to find a way that we can curb our spending, raise our debt limit and also grow our economy,” Mr McCarthy told reporters.
“But we’ve got a lot of work to do in a short amount of time.
“It is possible to get a deal by the end of the week. It’s not that difficult to get to an agreement.”
Hakeem Jeffries — the Democratic Leader of the House of Representatives — said both sides of politics agreed that “default is not an acceptable option, and must be avoided”.
What happens if an agreement isn’t reached?
If there is no agreement, the US Treasury will have to prioritise what payments to make from its tax receipts, but there would also be major flow-on effects for financial markets.
“The United States [would cease] to be able to pay its bills, so it defaults on its obligations, and that would be a huge problem for financial markets, because the United States is the world’s benchmark for credit worthiness,” Mr Picton said.
He explained that it would not only lead to a recession in the US, but it would also spark another financial crisis.
“Janet Yellen, the US Treasury Secretary, and Jamie Dimon, the head of JPMorgan, say that this will be catastrophic if it happened, and I think they’re right,” Mr Picton said.
“So it’s either they pay their bills or they don’t, and one is kind of business as usual, and the other one is a real catastrophe.
“It’s a really huge deal.”
Ms Yellen told an Independent Community Bankers of America meeting on Tuesday, local time, that the US would face a recession if it defaulted on its debt.
“Our economy would suddenly find itself in an unprecedented economic and financial storm,” she said.
“The resulting income shock could lead to a recession that destroys many American jobs and businesses.
“Time is running out. Every single day that Congress does not act, we are experiencing increased economic costs that could slow down the US economy.”
Analysis by ANZ Research suggests that the US Treasury would prioritise making interest payments to avoid defaulting on its debt, and agrees that a default would be “catastrophic”, although it says the probability of that occurring is very unlikely.
“We anticipate that a deal will be reached to suspend the debt limit for a few months to provide more time to negotiate a mutually satisfactory outcome,” wrote ANZ economists Brian Martin and Tom Kenny.
“The Democrats and Biden will most likely need to reach a compromise agreement with the Republicans that incorporates long-term budget savings [in] return for a reasonable increase in the debt limit or a lengthier suspension period.”
Has this happened before?
When it comes to lifting the debt ceiling, yes. In fact, the limit in the US has been increased 78 times since 1960.
Stalemates to lift the legislated limit aren’t new, either. Back in 1995 and 1996, the US government was shut down twice — for five days and 21 days respectively — because negotiations came to a standstill.
That resulted in close to 1 million workers being laid off, and negatively affected several sectors of the US economy.
More recently, in 2011, Congress agreed to raise the debt ceiling in exchange for future spending cuts two days before the US was unable to pay its bills, under then-president Barack Obama.
Even though a deal was struck at the 11th hour, it didn’t calm the nerves of the markets and shield the economy from the impacts.
The US credit rating fell, the $US plummeted and Wall Street suffered its most volatile day since the 2008 Global Financial Crisis.
During Donald Trump’s four years as president — who also cut taxes during his time in office — the debt limit was also increased three times.
“We’ve been here before, we had it through the Obama years. I think the debt ceiling was raised again during the Trump years, and they’ve always come to an agreement,” Mr Picton said.
“I would say that there’s a pretty strong chance they are going to come to some sort of agreement and be able to raise the debt ceiling or suspend it, as ANZ are suggesting.
“But we really can’t dismiss the risk of them not doing that in time and cause this fairly horrendous event to occur.”
However, the US has never actually defaulted on its debts before, meaning the US and global economy is rapidly approaching unchartered territory.
What does this mean for the US economy?
Not only would it cause a recession in the US, it could trigger the next global financial crisis, Mr Picton warned.
“The US government would effectively just stop paying people who are employed by the US government, so that includes public servants, military, public school teachers, nurses and doctors,” he said.
“But, bigger than that, bondholders around the world would not be paid the interest on their security for a period of time, and that would reverberate around financial markets.
“My expectation is that you would see credit really dry up in the world economy, the cost of credit would go up, households and businesses would find it much more expensive to borrow, if they were able to borrow.
“It would be a really bad thing for the world economy. It would potentially be like 2008 again.”
Could it affect Australia?
Australia “absolutely would” feel the effects of the US being unable to meet its obligations and defaulting on its payments, Mr Picton said.
He said the flow-on effects would be because of how interconnected the global financial market is with the US.
“If there’s a US default, it affects everybody, because the United States or US bonds are really the cornerstone of global financial markets, and the US dollar is the world’s reserve currency,” he said.
“So, if there’s a default in the United States, that affects the entire world.”
He expects that it would initially be more challenging for banks to borrow from overseas, which could result in higher interest rates.
“[Australia] would see that our banks would find it more difficult to borrow in offshore credit markets, particularly in that United States private placement market, and we [would] see cost of credit here in Australia increased,” Mr Picton said.
“We’re talking about higher interest rates for borrowers here in Australia because of global credit markets locking up.”
What happens next?
Right now it depends on the whether the Democrats and the Republicans can find a middle ground in negotiations.
The general expectation is that the debt limit will either be raised or suspended entirely, to allow for more time to negotiate before a potential default happens.
If a deal is not reached to raise the debt ceiling, some analysts say the US central bank, the Federal Reserve, will intervene and follow the blueprint it created in 2011.
“The aim of that blueprint was to ‘prioritise’ interest and principal payments on federal securities over Social Security payments, salaries for federal civilian employees, military benefits, unemployment insurance as well as other obligations,” Robert Abad from Western Asset noted.
Mr Abad said there was a “very low probability” that the US would default on its payments but, if it did, it would lead to similar, if not greater, volatility as that seen in the 2008 global financial crisis.
“In such a scenario, we would anticipate that Congress would move quickly to resolve the situation. However, a default would call the relative economic and political stability of the US into question,” he wrote.
Mr Picton also stressed that a default was unlikely to happen. He said a deal would be reached before the X-date.
“We think that the most-likely outcome is that they’re going to reach a deal but, because they’re running it so close to the edge, the risk of them making a mistake and something going wrong accidentally is increasing by the day,” he said.
“Politically, just the way that the numbers line up between the Republicans and the Democrats, it’s harder now for them to reach agreement and it has been previous years.
“The risks are climbing and the consequences if it goes wrong pretty drastic.
“We hope that they get it right.”