A deal was reached between House Speaker Kevin McCarthy & President Biden on raising the debt ceiling. What is ironic though is the whole political drama created around it. The debt ceiling could have been raised a long time ago. It could have been raised the week after Treasury Secretary Yellen announced the risk of defaulting. Was the U.S. government really going to default? Of course not. If the U.S. government never defaulted on its obligations since 1789, why would it suddenly default today, especially in an economy entirely based on credit? The recurrent news about the debt ceiling was pure political theatrics as the outcome was very predictable.
Why was it obvious that the U.S. government wasn’t going to default? As was aforementioned, the U.S. economy runs on a credit-based system. It means that debt is the principal financial instrument used to fuel capital across the economy. U.S. Treasury bonds are the most trusted and most used type of bonds. The Federal Reserve purchases them on a regular basis in exchange for supplying liquidity to the U.S. government when the tax revenue generated isn’t sufficient to fund government projects. The federal government runs on a deficit. It spends more than it generates revenue. Thus, borrowing from the Federal Reserve is a must for the U.S. government.
More importantly, allowing the U.S. government to default would have harmed the U.S. bond market. Government bonds have been seen as some of the safest investments worldwide. They are held by companies and countries the world over and used as collateral in all kinds of financial transactions. Defaulting would have made bond prices worthless and their yields extremely high. This is something that the federal government would have not allowed to happen.
Lastly, the U.S. dollar is threatened by the Chinese Yuan and the BRICS. Hence, the U.S. government couldn’t allow the Chinese Yuan to become the new world’s reserve currency. It is quite evident that the U.S. government was not going to default no matter what happened. Now the main question to ask ourselves is: at what cost? At what cost will the debt ceiling going to be raised?
The cost of raising the debt ceiling is that the real value of wealth creation will be reduced. It means that the value created will be used not as a surplus but to pay back the debt we are accumulating. Yes, debt is not free. It ought to be paid one way or another. It is like full-time working just to pay back your debt rather than working full-time in order to enjoy the fruit of your labor.
How is the debt going to be paid? Through tax revenues or more debt. If the debt is repaid through tax revenues, it means that the federal government will have to continue increasing the marginal tax rate on the middle and the upper classes, or it will have to keep borrowing from the Federal Reserve new debt to pay back its old debt. But doing so will potentially increase inflation and reduce people’s purchasing power. Using new debt to pay back old debt is digging oneself into a financial abyss. And this is what the U.S. government is heading towards; a financial abyss that the future generation will deal with.