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A bluffer's guide to... the US debt ceiling

Struggling to keep up with the political logjam in the US? Let us explain what’s going on – and why it matters to Ireland.

American stock markets have already lost value as investors prepare for a possible default - and those jitters will continue as long as Congress can't reach a budget deal.
American stock markets have already lost value as investors prepare for a possible default - and those jitters will continue as long as Congress can't reach a budget deal.
Image: Mark Lennihan/AP

THE UNITED STATES is in the middle of a political logjam that could quickly become a global financial crisis.

Essentially the two main parties – each of whom control one of the two houses of Congress – are at odds about how to start tackling the country’s growing budget deficits and to stop it from crippling the economy as quickly as next week.

So what’s it all about – and could it have any impact on the slow recovery over here? Here’s our simple-ish bite-size guide to what’s going on and how it might play out.

So what’s going on?

Basically it all revolves around what’s being called a ‘debt ceiling’. Unlike most other countries, America has a legal limit of the amount of national debt it’s allowed to run up. This dates back from 1917, when Congress passed a series of measures to finance World War I.

The most recent update to that limit was passed in early 2010, when it was hiked to $14.294 trillion. That’s just a pinch under €10 trillion at today’s exchange rate.

And the reason all of this is about to get important? Because the US is almost at the limit again – and is scheduled to hit it around about next Tuesday.

What happens if it reaches the limit?

While it’s generally accepted by all sides that the limit needs reaching, currently the dispute is over how exactly the US is going to stop its cycle of constantly borrowing, and then constantly raising its legal limit.

The effects of reaching the limit are therefore a little bit like hitting the limit on a credit card or an overdraft. Without any access to cash – and without the back-up of being able to borrow more money – America’s simply not going to be able to pay its bills.

The end result will be that America will have to start missing the repayments for its bonds – that is, its national debt – and as soon as it starts doing that, it’s going to lose its valuable AAA credit rating.

But why is a credit rating so important?

A good credit rating is important for any country – as we know in Ireland, a poor credit rating usually means a country will have to pay higher bond yields – that is, the interest rate on its national debt – but in America’s case it’s particularly pressing.

The US government has been running a budget deficit for several years now, but with international money markets always willing to lend it some money (again, the AAA rating comes in handy) that’s never been a problem.

But if the AAA rating is sacrificed as a result of the current political standstill, it’s going to become more expensive for America to keep borrowing – and if the government has to shell out more to keep the wolves from the door, it’s going to have to cut corners elsewhere.

That’s either going to mean massive cuts in government spending, or significant tax increases – with the end result being that the general public will have less to spend.

It’s could also have a knock-on effect on interest rates, which in turn will push up inflation.

How would that affect Ireland?

It’s generally agreed that Ireland’s economic recovery is going to be export-led. Wave after wave of economic data shows us that the Irish economy is only growing because of how successful our exports have been.

While we’re getting better and better at selling our goods and services abroad, the ‘native economy’ – best exemplified as domestic consumer demand – continues to sag as Irish people simply have less and less spare cash to spend.

Last year Ireland exported €89bn of goods and services – and the USA accounted for €20.7bn of that. America’s 308 million people are, relatively speaking, reasonably well-off – so the market is simply huge. And if America has less to spend, then Ireland will find it more difficult to sell itself there.

Is that it?

No. It’s also worth remembering that many governments keep some of their savings in US dollars – that is, they have invested in US government bonds as a reliable way of ensuring their savings don’t disappear. Before now, the world would never have had to contemplate the realistic prospect of America going into default.

If it does, then other governments will also take a hit – because they might not be able to cash in their US government bonds. What’s more, if they do ever get repaid, the dollars they’ll receive are less valuable – because the US inflation rate will slowly make those dollars less and less valuable.

And it gets worse. The mere notion of America defaulting in some way would be enough to send shock waves throughout the financial world. If the mighty America was to back out of paying its debts, then the entire bond market would begin to dry up and traders would simply pursue other options when they’re trying to make money. Why invest in bonds when there’s stock markets, currencies and commodities to trade instead?

That’s where stuff begins to get very dangerous for the likes of Ireland. As we reported yesterday, Ireland’s liabilities under the EU’s new bailout mechanism could reach €11.1 billion – that’s over a quarter of our annual income – if bigger countries like Italy and Spain are priced out of the markets and need emergency assistance.

The end result could be catastrophic. Major European economies could find themselves in need of financial aid, and other countries will find it more and more difficult to summon the cash to bail them out. All the while, the existing savings of governments will already be depleting because their US government bonds are slowly haemorrhaging value.

So how can all of this be stopped?

The American political environment has now become so polarised and bitter than few people will be satisfied with a short-term solution – so a relatively small increase in the debt ceiling won’t really solve the problem, it’ll just postpone it.

Both Democrats (who control the Senate and, of course, the White House) and Republicans (who control the House of Representatives) want to find a more medium-term solution – and to do so before next Tuesday’s deadline.

This means coming up with a plan that narrows the gap between what America is spending and how much it’s earning, so that the government is less reliant on loans from outsiders. Unfortunately, so far there’s no sign of an agreement between the two parties.

Republicans generally believe in smaller government – meaning they’d prefer to cut government spending so that the country can get by with lower taxes. Democrats would rather maintain the current level of spending, which they see as a good thing for society, and make up the difference by introducing extra taxes on those who can afford it.

While the Republicans have been able to make some progress by pushing their own plans through the House, every proposal has so far been killed off by the Democrat-controlled Senate.

Whether the US will ultimately have to default or not is anybody’s guess. For what it’s worth, Paddy Power reckons a deal will be struck – but if the logjam continues as it has this far, then the weekend’s negotiations could be very tense and fraught indeed.

More: Republicans to press new vote on lifting US’s debt ceiling >

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About the author:

Gavan Reilly

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