October 7, 2013 12:16 pm
Updated: October 16, 2013 9:53 am

The debt ceiling and potential impact on Canada explained

President Obama addresses the press as Republican House Speaker John Boehner looks on.

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So what is the debt ceiling exactly—and more importantly, what does it mean for Canada if the U.S. government hits it?

It’s a complicated question everyone from big financial investor-types and lawmakers are trying to unpack now, 10 days ahead of a deadline set in Washington to either raise the ceiling, which would allow the U.S. Treasury to borrow additional money to continue funding the business of government, or not, leaving the Treasury in a position where it will run short of cash.

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If the U.S. government runs short of money to cover its bills, which include everything from federal social programs to interest on $12 trillion of U.S. bonds held by banks, other governments, pension plans and the like, Washington could default for the first time in its history.

What happens next would be unprecedented and therefore isn’t exactly clear. But by most accounts, it isn’t pretty and could be downright scary, with a situation unfolding similar to what played out in 2008, when giant U.S. investment bank Lehman Brothers tipped into bankruptcy, pouring jet fuel on a global financial crisis that went on to scorch the U.S. economy and drag the world into recession.

Many, including the U.S. Treasury Dept. itself, suggest a U.S. default would dwarf the Lehman collapse.

Last week, in the hopes of getting U.S. politicians to end a stalemate and pass legislation allowing Washington to lift the ceiling past the current $16.7 trillion, the U.S. Treasury issued its own assessment of the ramifications of a breach.

“A default would be unprecedented and has the potential to be catastrophic,” the Treasury report said.

“Credit markets could freeze, the value of the dollar could plummet, US interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse.”

Let’s hope that doesn’t happen.

Read more: US govt shutdown enters 2nd week, no end in sight

But first let’s address what the debt ceiling, or limit, is and why U.S. politicians are at odds over whether to raise it or not.

The U.S. debt limit was enacted in 1917 to help the U.S. Congress more efficiently fund World War One, and has been raised regularly to cover shortfalls in Washington’s spending budget since. In short, when the U.S. federal government has been short, it borrows to cover the difference – like most other governments.

But in 2011, Republicans (read: newly-elected right-wing Tea Party members of the GOP) dug in, refusing to approve the raising of the debt ceiling unless future spending cuts were agreed to, a position that led to the Budget Control Act 2011, which has implemented across-the-board spending cuts already.

The current impasse is now about “defunding” health legislation enacted by the Obama Administration in 2010 that has opened up health coverage to millions of uninsured Americans, but added costs on the federal budget.

As mentioned above, failure to raise the debt ceiling will mean the U.S. Treasury won’t be able to cover the government’s obligations, and immediately after the deadline is breached, the dominos will start to fall.

Stock markets in the United States and elsewhere will freefall as investor confidence evaporates. Interest rates for the U.S. government and its bonds will surge, increasing the cost of borrowing globally, while the broader economy – including here in Canada – will start to feel a broad-based slowdown.

That’s how many say events could go, anyway. A fuller breakdown from Bloomberg News can be found here.

“Among the dozens of money managers, economists, bankers, traders and former government officials interviewed for this story, few view a U.S. default as anything but a financial apocalypse,” a widely read report from Bloomberg published over the week said.

Stock markets are already trembling, while interest rates on U.S. bonds are rising as the risk of default builds.

A hardening of positions from the Obama White House and House Repulicans over the weekend has heightened tensions.

“Markets are getting more and more on edge,” Doug Porter, chief economist at Bank of Montreal said in a note Monday.

John Boehner, the House Speaker for the Republican-controlled House of Representatives, said Republicans would not agree to lift the ceiling if no spending concessions are made. “We are not going to pass a clean debt limit” he said in a newspaper report.

Asked about the risk of default, Boehner said, “That’s the path we’re on.”

“Boehner continues to say he will not allow the government to default, while President Obama continues to reject attempts to make approval of the debt ceiling conditional upon anything else, and hence the impasse,” Scotiabank economists said in a note Monday morning.

Still, with the stakes as high as they are, Canadian economists and financial executives suggest the U.S. federal government will drop its partisan quarrel, at least temporarily, to get a deal done and avoid a default.

“I think because of the [potentially damaging] impact of that, hopefully we won’t see it occur,” Gord Nixon, chief executive of RBC said in an interview last week.

“Our base case scenario remains that a debt ceiling agreement will materialize and default will be averted,” the Scotiabank note said.

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