What’s US debt crisis?
Everyone is talking about this new financial crisis. Stock markets all over the world are plunging in response to the US debt crisis. In our country too, the sensex is on a downward path since the time the news about this crisis broke. Share values of Indian IT companies whose revenues are heavily dependent on the US economy are falling steeply in the response. What exactly is this US debt crisis?
Thanks to the jargon used in most of the news reports, there are high chances that a person who is not an expert in economics will not be able to understand the phenomenon completely. Indian media being obsessed with the crisis’ impact on Indian economy (rightly so) ensures that you will not get to know the crux of the matter. Only thing you can make out of this whole situation is that ‘something very bad’ is happening to the powerful US economy and it may affect our economy too. If you belong to the group of people who want to know what this crisis is all about, then this post is for you. Let me try to describe the phenomenon in a layman’s language.
Why does a country borrow?
When a country spends more than it earns through revenues, it has to borrow money from the global market to meet the expenditure. The country also needs to pay back the debt in installments over a period of time. This is called as debt obligations. So once a country borrows, the expenditure of the country shoots up. Hence the next time the country has to borrow more to meet not just the expenditure but also the debt obligations. From this you can understand that the countries’ debt amount goes on increasing with time as they borrow more and more. United States is no different and is also under a huge debt of $14.3 trillion at present. In fact, lending money to US is considered as a safe and promising investment.
It is very common for a country to spend more than its revenues. So it is also normal for a country to borrow. In 2011 federal budget, the US government estimated the expenditure at $3.82 trillion and revenues at something more than $2 trillion. That implies a deficit of around $1.5 trillion. Under normal situation, US govt. would have borrowed and compensated this deficit. But they couldn’t because of the debt ceiling that is set by the US Congress.
What is debt ceiling?
Debt ceiling is a cap set by the US Congress on the amount of debt the government can borrow. The limit was first set in 1917 at $11.5 billion. Whenever the govt. reaches the ceiling, it can’t borrow more. Every time the cap is reached the Congress approves a higher debt ceiling and directs the treasury to borrow more. To raise the cap, a legislation has to be passed in both the houses of the Congress: the Senate and the House of Representatives. The cap was last raised to $14.3 trillion which the current govt. reached in May this year. Since then the US is not being able to borrow more debt.
Why did not the US Congress raise the ceiling again and borrow?
This is where the politics has come into the play. Raising the debt ceiling would have been the obvious step as it has happened several times in the past: both under the Democrats and the Republicans. But this time around the Republicans (who are in opposition now) raised reservations over increasing the ceiling. They did not agree to raise the ceiling unless huge spending cuts without tax increase were agreed on. The Tea Party movement that started in 2009 with a focus on reducing government spending and regulation helped the republicans to win a substantial number of seats in the 2010 midterm elections. The Republicans fought the election on the planks of cutting federal spending and stopping tax increases. Sticking to those lines, they refused to support raising the debt ceiling unless their demands were met. Since the Republicans control the House of Representatives, the raising of debt ceiling could not be approved by the house of Representative without their consent. President Obama and his party is in minority in the house. So there was no other way left for the Obama administration and they had to reach a settlement with the opposition as quickly as possible.
What happened then? Did the two parties agreed on some settlement?
As the US had already reached the debt ceiling in May, they needed to tackle the issue immediately. It was apprehended that after August 2nd if the US govt. couldn’t borrow, then US Treasury Department would have run out of money to pay its bills. That could have resulted in widespread panic all over the world because a large number of people and organisations receive payments from the US.
At the end, both sides agreed to control the deficit without raising taxes and by spending cuts. The House of Representatives approved legislation to raise the U.S. debt limit by at least $2.1 trillion and cut federal spending by $2.4 trillion or more. The deal legislation says,
The two-stage plan calls for $2.4 trillion in savings over the next decade, although the Congressional Budget Office pegs the savings at $2.1 trillion. It also authorizes an increase in the nation’s borrowing limit through the end of 2012. A special congressional committee to recommend long-term fiscal reforms is also part of the package.
So a catastrophic event was averted? What is the outcome? All’s well?
Yes, the result could have been catastrophic if the cap wouldn’t have been raised. But the market all over the world has reacted nervously and are worried over the US handling of the debt problem. In an interesting development, USA lost its AAA credit rating to AA+. In common language that means now lending money to US is not safe (AAA rating means safe) and little risky. That also means the interest rates will increase slightly making it difficult for the US to raise money through debt. The current agitation in the financial markets are in reaction to this developments.
You can also refer to this article on ‘The Guardian’ for more clarification.
For more on the sovereign debt rating, you may like to check this Times Of India article. It describes the concepts in simple language.
Check the Wikipedia page for the US debt ceiling crisis here. [Warning: It uses too many jargon]