Washington faces another debt crisis

WANG XIAOYING/CHINA DAILY

The United States has once again reached a critical point in its debt crisis, with its outstanding unfunded federal government debt reaching a staggering $31.41 trillion in December 2022. While the US Treasury Department has taken emergency measures to avoid breaching the debt ceiling, the ongoing power struggle between Democrats and Republicans threatens to deepen the crisis.

The fear of a debt default looms large, with US Treasury Secretary Janet Yellen warning Congress on Monday that the US might be unable to pay the bills as early as June 1 if lawmakers didn't raise or suspend the debt limit, which could have severe global consequences. On Thursday, Senate Democrats pressured Republicans on the increasingly menacing debt ceiling impasse, saying reductions in government services will be painful if a bill Republicans recently pushed through the House becomes law.

A potential downgrading of the US sovereign debt rating, a weakened US dollar as a global reserve currency, and a global financial crisis are all possibilities.

Printing currency notes and issuing bonds have been the two major policy tools of the US to stimulate its economy. As a result, the dollar standard has evolved into a debt standard for the US.

The debt ceiling is essentially the maximum limit on the total amount of federal government debt. It is a legal restriction set by Congress and used as an important means to limit federal government debt. The debt ceiling covers 99 percent of the total amount of US federal debt, including publicly held debt (used to finance budget deficits) and debt issued to federal government accounts (used to fulfill federal obligations).

The debt ceiling was set to prevent the federal government from borrowing recklessly. It was legally established in 1917, and since then, Congress has set the limit on the issuance of bonds through legislation. Yet the US debt ceiling is a symbolic limit, because with the expansion of national credit, the legal debt limit has been continuously raised. From 1997 to 2022, for instance, the US has raised the debt ceiling 22 times.

Over the past 20 years, the statutory debt limit has increased from $6.4 trillion to $31.41 trillion. At the end of the 2022 fiscal year, the total US federal debt was $30.93 trillion, accounting for a whopping 121.5 percent of GDP, with the total outstanding public debt exceeding the combined economic output of China, Japan, Germany and the United Kingdom.

The US federal debt has risen nearly 60 percentage points since before the 2008 subprime mortgage crisis. And since the outbreak of the COVID-19 pandemic, the scale and speed of US fiscal expansion have been unprecedented, in order to stimulate economic recovery. The Donald Trump administration and the Joe Biden administration have launched seven rounds of fiscal stimulus bills worth $3.8 trillion and a net debt issuance of $6.2 trillion, almost twice the earlier amount following the subprime crisis in 2008.

The increase in debt is fueled by the monetization of debt. At present the Federal Reserve is the second-largest holder of US government debt. The Fed purchases government bonds in the secondary market and gives the newly printed currency bills to primary dealers who then transfer them to the Treasury Department.

The expansion of the Fed's balance sheet, when combined with the federal government's fiscal deficit and the size of the Fed's asset and liability in the balance sheet (or holdings of government bonds), is the process of debt monetization. Also, the proportion of US Treasury securities held by foreign creditors declined significantly between 2008 and 2020, while the proportion held by the Fed increased drastically. And to ensure the US government's spending growth rate does not decline, the federal government must continue to rely on the Fed to finance its Treasury securities.

Unbridled printing of money has not only led to excessive global liquidity and debt expansion, but also puffed up the Fed's balance sheet to an unprecedented $8.9 trillion. In response to the high US inflation rate, which recently hit a 40-year high, the Fed raised interest rates 10 times, with a cumulative increase of 500 basis points — the most aggressive hike cycle since the 1980s.

But the aggressive rate hikes have also significantly increased the cost of servicing the US' federal debt. According to Congressional Budget Office estimates, due to the combined effects of high inflation and aggressive interest rate hikes, the US federal debt will incur an additional $2.5 trillion in servicing costs between the 2022 and 2031 fiscal years.

Essentially, the US can continue to borrow and roll over its debt as long as its fiscal revenue can cover the government's interest payments, thanks to the US dollar's dominant international currency status.

However, the sharp rise in US debt poses a serious threat to this strategy. In the long run, the federal government's debt won't be sustainable. Although the US has not yet defaulted on debt, the political turmoil and financial market shocks caused by stalemates in debt negotiations between the administration and Congress should not be underestimated.

Due to the increasing polarization between the Democrats and Republicans, the debt ceiling has become a key bargaining chip in political games in the US. Interestingly, most of the debt ceiling standoffs occurred when the Democratic Party did not control both houses of Congress.

The current situation in the US is reminiscent of 1995 and 2011, when the two most tense standoffs over the debt ceiling occurred. In 2011, for example, the debt ceiling negotiations between the Barack Obama administration and the Republicans who controlled the House of Representatives were deadlocked right until the day when the Treasury Department ran out of funds.

This intense standoff led to the Standard &Poor's downgrading the US sovereign credit rating for the first time from AAA to AA+, triggering intense turmoil in global stock and bond markets, with gold prices soaring nearly 13 percent, the S&P 500 plummeting 17 percent in a month, the Dow sliding 15 percent, and the 10-year Treasury yield declining 82 basis points.

Now, with Congress divided again, the stalemate over debt ceiling is likely to become another headache for the struggling Joe Biden administration, as the Republicans who are in majority in the House of Representatives and control the purse strings will make every effort to block the passage of a bill to raise the debt ceiling.

This will not only impede the Fed's asset liability plan to combat high inflation, but also could accelerate the sale of US Treasury bonds, damage the credibility of the US dollar as an international reserve currency, and trigger another global financial crisis.

The author is deputy director of the Institute of American and European Studies at the China Center for International Economic Exchanges.