American and global financial markets are again staring at the abyss of default due to the failure of US politicians to agree a new budget which has closed down some government services. The failure to increase the amount of money the US government can borrow – the debt ceiling, threatens to cause the US to default on its debt.
The debt ceiling was introduced in 1917 during the First World War. At the start of the war, the US was neural and it was only when a number of US ships were torpedoed by German submarines that they became involved on the side of the British, French and Russians.
Wars cost money and generally are not budgeted for. The President, Woodrow Wilson had to continuously go to Congress to get permission to raise more money. In order to circumvent this process the Congress agreed to allow him to borrow as often as necessary.
In order to ensure that he didn’t get out of hand, a debt ceiling was introduced by the passing of the Second Liberty Bond Act, 1917. This Bond required that all US debt had to be redeemed with gold. In later years, the US Treasury did not have sufficient gold reserves to cover borrowings and in 1933, President Franklin D. Roosevelt retrospectively revoked the gold clause.
The debt ceiling was set at $16.4 trillion US dollars in 2011 and despite continuous negotiations Democrats and Republicans cannot agree to a new budget. Democrats want to raise taxes on higher earners while Republicans want to reduce spending particularly on health care for poorer people. In the meantime, the rating agencies have warned that any default by the US government will result in a credit review and most likely be followed by a credit downgrade from its current AAA status. That would increase the cost of borrowing for the US and ultimately, the ratings agencies wish to see a plan that will reduce the deficit.