US debt ceiling: What is it and how devastating would a default be?

Efforts to prevent the United States reaching its debt limit and to avert a potentially catastrophic default on loan repayments on Wednesday move to the Senate, where the vote on the proposal to raise the debt ceiling takes place.

President Joe Biden and leader of the House of Representatives, speaker Kevin McCarthy, had spent the Monday memorial day holiday shoring up support among Democrats and Republicans respectively for the agreement.

The pair had agreed a plan on Saturday for the debt limit to increase and for spending caps and work requirements to be introduced. The agreement between the leaders must now gain approval of the two chambers of congress in less than a week before the default deadline is reached on Monday.

A single opposition vote could derail progress through congress and bring the US into its first ever default, with potentially disastrous consequences for the global economy.

What’s happening this week?

Members of the Republican majority House of Representatives are to vote on the proposed agreement on Wednesday. If approved, the proposal will move to the Democrat-controlled Senate on Friday.

But it first faces an uphill battle in the House as Republican representatives have already voiced their opposition.

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Ten far right leaning House Republicans are expected to vote no, believing controls on spending in the agreement to be insufficient. Republicans generally seek to shrink, rather than expand, the country’s debt.

Some Democrats too are unhappy with the deal. The deal’s planned 3.3% increase in defence spending may lead to members of both parties seeking amendments to make sure military spending rises in line with inflation, which in the US is just below 5%.

Passage in the House on Wednesday is key to bringing the vote to the Senate on Friday.

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What’s in the debt ceiling deal?

The main purpose of the deal is to increase the US debt limit from $31.4trn (£25.3trn). The agreement does this by suspending the borrowing limit until January 2025 – after the next US presidential elections – rather than setting a new level.

Biden and the Democrats have made concessions to Republicans in the hopes they will back a deal. As Republicans are sceptical of government spending and seek smaller government, the deal promises spending cuts and policy concessions.

Quite how deep those spending cuts are depends on who you ask.

The White House is saying government spending would come down by $1trn, though official figures have not been released. The New York Times are reporting cuts of $136bn (£109.7bn) will be made.

Under the agreement, some social welfare recipients will be subject to new work requirements.

The bill would also end the student loan freeze Biden introduced and require former students to recommence payments.

It also revokes funding for the US tax collection authority, the IRS. Democrats had dedicated $80bn for the authority to hire more employees to boost tax enforcement, collecting more funds to implement state spending plans.

Ultimately the agreement is trying to stop a government shutdown. A deal is needed because any extension, or pause in the debt limit, needs the approval of congress.

Why does defaulting matter?

As the world’s largest economy has never before defaulted the exact consequences are uncertain but are likely to be catastrophic to the US and global economy.

The US would run out of money and no longer be able to pay its bills. Civil servant wages, social welfare payments, health insurance – known as Medicare – would go unpaid.

If the US no longer pays interest on its bonds, IOUs it issued to raise funds, it would default on debt payments.

The country’s credit rating would go down If it defaults on debt payments. A vital way the country raises money – selling bonds – could be at risk as markets will see US government debt as insecure and charge more to lend to the US.

Economic research organisation Moody’s Analytics said a prolonged period where US bills can’t be paid would lead to a nearly 20% drop in stock prices, economic contraction of 4% and the loss of more than seven million jobs.

The White House Council of Economic Advisers estimated the economy could shrink by as much as 6.1% after such a prolonged period.

Global shocks

The country would likely enter recession, which would harm the global economy as the US trades with so much of the world and is the bedrock of the worldwide financial system.

A fall in the value of US bonds would also harm economies across the world as investors could become concerned about other countries defaulting and seek to be paid more to lend to other nations.

US bonds and stocks are owned by pension funds across the world and with a drop in their values would come a drop in pension values.

When could default happen?

To prevent default an agreement must be reached by Monday 5 June, which the US Treasury Secretary, Janet Yellen, set as the deadline to raise the debt ceiling beyond the current $31.4trn (£25.3) limit.

A date as early as 1 June had been thought to be the default date before the precise deadline was set by Ms Yellen.