U.S.

Debt Ceiling Crisis & Global Economic Implications

Aryan Sethia

Roll no. - IPM05015

Email Id - [email protected]

Integrated Programme In Management, IIM Rohtak

TERM IV – Macroeconomics II

Dr. Piyali Majumder

Sep 12, 2024

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 Abstract

This report investigates the U.S. debt ceiling crisis and its macroeconomic consequences,
focusing on global spillover effects and the potential impact on India. It provides a detailed
analysis of historical U.S. debt trends, debt-to-GDP ratios, and market indicators like the U.S.
Dollar Index and corporate bond spreads and how such various macroeconomic variables impact
global financial stability. The report further assesses the Sustainability of the U.S. debt Ceiling
and along with it discusses the macroeconomic strategy of inflating away the debt. It also
explores India's de-dollarization efforts, examining how these strategies can reduce vulnerability
to U.S. fiscal instability.

Background/Motivation

“The U.S. debt ceiling crisis is a ticking financial time bomb”. This statement effectively
encompasses the entire background of this study.

Understanding the definition of debt ceiling will build the foundation of this study and
appropriately help us understand its background. This ceiling is essentially a limit set by the
House of Congress on the amount of national debt the central/federal government can have. It
refers to the maximum amount of money the federal government can borrow to finance its
operations or pay its dues. Since the 1960s, it has been raised over 78 times in order to
accommodate the government's rising fiscal expenditures (Neufeld & Routely).

It was in the year 2023 that this issue re-emerged as a global focal point when the U.S.
Department of Treasury reached its debt ceiling of 31.4 trillion dollars. By the month of January
2023, the federal government had breached its debt ceiling limit, indicating the risk of potential
default by the start of June 2023, mirroring the crisis of 2011 and 2013.

Motivation for the Study

“When America sneezes, the world catches the cold”

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 As I delved deeper it became crystal clear that the U.S. debt ceiling is not merely an
American Problem, it has significant global financial implications. Countries across the world
maintain the U.S. dollar as the largest proportion of their financial reserves and have
substantially invested in U.S. Treasury bonds, considered to be the safest form of Investment.

This is why I felt the need to understand exactly how this crisis may lead to a significant outcry
in terms of market volatility, depreciation of the U.S. dollar, and disruptions in global trade with
ripple effects reaching our borders too. As a responsible citizen and an avid reader of the
economic times from the last year, I have been personally following the 2023 U.S. debt ceiling
crisis. How is it that in this globalized world, dollar hegemony has allowed the U.S. to
continuously take on debt? Thus Identifying vulnerabilities and exploring potential strategies to
mitigate this financial crisis hence becomes important in order to reduce the effects of a potential
fallout on India’s financial system be it in terms of Increased cost of raising capital, downward
trends in the stock market, or even the decrease in India’s export competitiveness due to
depreciation of the U.S. dollar.

Objective

The primary objective of this study is to conduct a comprehensive analysis of the U.S.
debt ceiling crisis, exploring its implications on the global financial system and India.
Specifically this study will investigate:

1. The Potential global macroeconomic spillover effects that arise/may arise from the U.S.
Debt Ceiling crisis and an unprecedented U.S. default, exploring how close has
America’s economy been to such a situation and its implications, uncovering the
interconnectedness of the world’s financial markets.

2. Address the Long-term concerns regarding the sustainability of the U.S. economy in
terms of the continuous raising/suspension of the debt ceiling limit till the point of no
return.

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3. Impact of a Potential U.S. Default on the Indian Financial System and the Path towards
de-dollarization.

Theoretical Framework

● Mundell-Fleming Model:
○ Concept: This model extends the IS-LM framework to an open economy,
incorporating international trade and capital flows. It examines how monetary and
fiscal policies affect an economy with different types of exchange rate regimes
(fixed or flexible)(Mankiw, 2009, pp. 339–361).
○ Effects:
■ Under Floating Exchange Rates Regime: When a country implements
expansionary monetary policy (e.g., lowering interest rates), it often leads
to a depreciation of its currency. This is because lower interest rates
typically drive capital outflows as investors seek higher returns elsewhere,
making domestic exports cheaper and boosting the trade balance.
Conversely, expansionary fiscal policy (e.g., increased government
spending) can cause currency appreciation if it leads to higher interest
rates that attract foreign investment.

In the Upcoming sections, we will empirically substantiate potential fluctuations in

macroeconomic variables and explore the macroeconomic spill-over effects caused by these
fluctuations as established using this theoretical framework.

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 Research Question

The main focus of this project can be summarized in the following question:

"What are the macroeconomic implications of the U.S. debt ceiling crisis and a potential U.S.
default for the World & India ?"

Given the interconnectedness of global financial systems, this research seeks to understand how
a crisis in the world’s largest economy could ripple across borders to even an emerging market
like India, affecting everything from stock market performance to foreign trade and currency
valuation.

Data and Methodology

Introduction & Methodological Framework

This study delves into the macroeconomic effects of the U.S. debt ceiling crisis and the potential
fallout of a U.S. default on both the global economy and India. By combining a qualitative case
study approach with a historical analysis, the research explores the 2011 U.S. debt ceiling crisis
and the 2023 debt ceiling standoff, aiming to uncover persistent economic patterns and emerging
risks. Additionally, the study integrates a decade-long review of interest rates, total debt, and
debt-to-GDP ratios. This seeks to shed light on the critical transmission channels through which
a debt ceiling crisis and a potential Default could influence the global financial system and
Indian economy, offering a nuanced perspective on these complex economic phenomena.

Data Analysis

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(MacroTrends, VIX Volatility Index - Historical Chart.) An important statistical measure of
volatility or risk in financial markets can be calculated by the expected volatility of stock prices
implied by the S&P 500 Index also known as VIX. Both of the highlighted timelines indicate a
period wherein the debt ceiling crisis emerged in the U.S. and in such a period, a significant
uptrend in market volatility is visible. This data highlights higher market volatility indicating a
significant loss in investor confidence/rise in risk in the overall stock market.

The data represents the Option-Adjusted Spread (OAS) of the ICE BofA BBB US Corporate
Index, which is part of a broader index tracking the performance of U.S. investment-grade
corporate bonds. An uptrend in corporate spreads—as visible in both the years; 2011 and 2023
during the timeline of the debt ceiling crisis—indicates that investors perceive higher risk in
lending to corporations. When corporate spreads widen, it signals that lenders are demanding a
higher return (or yield) to compensate for the increased perceived risk of default or financial
instability.

These graphs (Yahoo Finance) indicate/depict the DXY or the U.S. Dollar Index. The DXY
calculated the value of the U.S. dollar relative to a certain basket of foreign currencies. During

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the 2011 debt ceiling crisis, the dollar experienced a significant depreciation of approximately
8.7%. Similarly, from January to June 2023, amid debt ceiling concerns, the dollar weakened by
about 3.7%, which, while notable, was roughly half the decline observed during the 2011 crisis.

This section (International Monetary Fund, Currency composition of official foreign exchange
reserve - IMF Data, 2024) highlights that 58.85% of the world's foreign currency reserves are
held in U.S. dollars as of 2024, reflecting the global dependence on the dollar as the dominant
reserve currency. Furthermore, (Treasury International Capital System, Table 5: Major Foreign
Holders of Treasury Securities) we observe Japan and China among the top 2 holders of U.S.
Treasury securities. Both of these data have been presented to substantiate the fact that nations
across the world are financially vulnerable to fluctuations in the U.S. Dollar and U.S. Treasury
Bonds(considered risk-free)

By 2023, the U.S. federal debt had risen to 123% of GDP, sparking significant concerns about
the country's long-term fiscal stability. Total debt (Monthly statement of the Public Debt
(MSPD): U.S. Treasury Fiscal Data) reached $33.17 trillion, more than doubling from $17.82

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trillion in 2014, reflecting a steep increase in borrowing over the past decade. During this period,
the average interest rate (Fiscal Data.Treasury gov, Average interest rates on U.S. Treasury
securities) on federal debt also climbed, from 2.40% to 2.97%, increasing the cost of borrowing.

One of the most effective ways to evaluate a country's fiscal health is by examining its debt in
relation to its gross domestic product (U.S. Bureau of Economic Analysis, Table 1.1.5. Gross
Domestic Product ), as this ratio provides a clearer sense of the nation’s capacity to service its
debt. Rather than focusing solely on the debt figure, the debt-to-GDP ratio offers a more
comprehensive view of the debt burden relative to the country’s overall economic output. A
notable observation that we can interpret is the U.S. debt-to-GDP ratio had surpassed 100% for
the first time in 2013, when we could observe both debt and GDP were approximately $16.7
trillion and it has increased continuously since then with 123% being the Debt-to-GDP ratio in
2023.
Results and Discussion

In this section, we will discuss the macroeconomic effects of the U.S. debt ceiling crisis and a
potential U.S. default, and consequently explore its consequences on the global financial
markets. Adding on we will be trying to map the potential effects on the Indian Financial system,
along the way. Through a detailed exploration, we will try to understand the economic intuition
behind key financial movements, providing a nuanced understanding of the global
macroeconomic spillover effects, the sustainability of the U.S. debt ceiling, and India’s pathway
toward de-dollarization. Additionally, we will also explore the macroeconomic strategy of
“inflating away the debt”—an intuitive strategy that may prove to be the cornerstone for solving
the U.S.A’s unsustainable Debt-to-GDP ratio and the overall Debt Ceiling Crisis

1. Global Macroeconomic Spill-Over Effects of the U.S. Debt Ceiling Crisis

a. Financial Market Volatility and Economic Intuition

From the Data & Methodology section, we can clearly infer how financial market volatility tends
to intensify when political uncertainty surrounds critical economic policies, such as in this case
the U.S. debt ceiling. Historically, as inferred from the graph, during debt ceiling standoffs, we

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observe heightened risk aversion among investors as the prospect of a U.S. default looms not just
over the domestic economy but over entire global financial markets​.

The underlying economic intuition behind this increased volatility index can be associated
with/driven by the investor's fear or uncertainty about the government’s ability to finance its debt
obligation, leading to default concerns with respect to the U.S. Treasury Bonds which are
essentially considered risk-free. Thus investors re-assess their risk exposure and thereby try to
move away from these riskier assets to more liquid and safer assets. This increase in demand for
liquidity and exit from riskier assets(sell-off triggered) raises market volatility as seen above.

In terms of global spill-over effects, the U.S. financial markets are deeply interconnected with
global capital markets. When investors withdraw from riskier assets and in turn favor safer more
liquid assets such as Gold or Swiss Francs, significant capital outflow can be observed in not
only the domestic economy of the U.S. but many countries wherein a majority of U.S. Treasury
securities are held. No doubt, emerging markets like India will stand particularly vulnerable to
these shocks. When foreign investors withdraw capital from riskier assets, such as stocks in
India, in favor of safer assets like gold or Swiss francs, Indian financial markets experience
volatility and capital outflows. This creates tighter financial conditions, increases the cost of
capital, and exacerbates market instability.

Another clear sign of distress during a debt ceiling crisis is the widening of corporate bond
spreads. This reflects the increasing gap between the yields on corporate bonds and U.S.
Treasury bonds. When investors perceive higher risks in the financial system—driven by fears of
a U.S. default—they demand higher yields on corporate debt to compensate for the increased
likelihood of default.

The widening of these spreads is rooted in the economic intuition i.e. when investors see the
government itself struggling to honor its debt, they start questioning the financial health of
private corporations, too. This uncertainty leads to a flight from corporate bonds, which raises
borrowing costs for companies. Consequently, businesses start to face higher financing costs,
which limits their ability to invest, hire, or expand.

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Hence this effect on the global cost of capital because of U.S. corporations, which are major
global players, is substantial. If their borrowing costs rise, this reduces their investment and
hiring, leading to a slowdown in global economic activity. For countries like India, which rely on
global capital markets, rising U.S. interest rates and corporate spreads make it more expensive to
raise capital, leading to a slowdown in domestic investment and GDP growth.

2. Sustainability of the U.S. Debt Ceiling: Can the U.S. Keep Raising It?

Understanding why debt growth has been so significant for the U.S. is the first part of the answer
that we must address. We see that it is not a recent phenomenon; the U.S. has managed debt
since its inception(The history of the debt). Following the American Revolutionary War, the
nation’s debt was over $75 million by 1791. Although the debt briefly shrank in 1835 due to
federal budget cuts and the sale of government-owned lands, economic downturns quickly
caused it to rise again, especially during the American Civil War. Between 1860 and 1865, the
debt surged by over 4,000%, increasing from $65 million to nearly $3 billion.

The pattern of rising debt continued into the 20th century, with the national debt hitting
approximately $22 billion after World War I. Furthermore, as go down more recent history,
various events including but not limited to, the Afghanistan and Iraq Wars, the 2008-09 mortgage
market crash, and COVID-19, have had significant impacts thereby causing sharp spikes in total
public debt. From FY 2019 to FY 2021 alone, federal spending increased by nearly 50%, driven
by pandemic-related stimulus packages and government spending, alongside reduced tax revenue
due to widespread unemployment. By examining these historical shifts and the critical
debt-to-GDP ratio, we gain a clearer understanding of how the U.S. debt has reached its current
levels, shaped by economic pressures and the financial demands of responding to national crises.

To understand this part from an economist's intuition perspective we can clearly assess how
continuous increase in total debts can be linked with continuous/chronic budget deficits as
essentially another way to think of debt is accumulated deficits. To cover these deficits, the U.S.
issues Treasury bonds. This is where the dollar’s role as the world’s reserve currency comes into
play as it allows the U.S. to issue debt cheaply due to the global demand for dollar-denominated
assets.

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The next part of this answer included assessing the ability of the U.S. to continuously raise its
debt ceiling without major economic repercussions taking into account the unique position of the
U.S. dollar as the global reserve currency.

In the near term, the U.S. will likely be able to continue raising the debt ceiling without facing
immediate financial fallout, largely because global demand for U.S. dollars remains robust. The
dollar’s status as the world’s reserve currency ensures steady demand for U.S. Treasury
securities, enabling the government to finance its operations despite rising debt levels. However,
as the debt-to-GDP ratio continues to climb—currently surpassing 120%—concerns about the
long-term sustainability of this strategy are growing.

Essentially what is happening is when investors begin to doubt/question the government’s ability
to manage/finance its debt without resorting to inflationary policies, they start to demand higher
interest rates as compensation for the increased risk they might face. Henceforth making
borrowing more expensive for the U.S. government. Over time, a loss of confidence in the
dollar’s role as the global reserve currency could trigger capital outflows, as investors move their
assets to safer havens. Such a scenario could potentially destabilize global markets, raising the
risk of a broader financial crisis.

Macroeconomic Strategy of “Inflating Away the Debt” in the U.S. Debt Ceiling Crisis
We can understand this strategy (Reis et al., n.d.) with the help of an example. So back in 1970,
the median house price In the U.S. was approximately 24000 dollars, today the same median
house would cost us 420,800 dollars. (U.S. Census Bureau and U.S. Department of Housing and
Urban Development, Median Sales Price of Houses Sold for the United States [MSPUS],
retrieved from FRED, Federal Reserve Bank of St. Louis;
https://fred.stlouisfed.org/series/MSPUS, September 11, 2024).The reason this same basic
commodity is so expensive today is of course due to inflation. Now if we had taken a full
mortgage on the 1970 sales price of a median house costing 24,000 dollars, paying this loan back
in 2024 would be so much easier considering our nominal wages have become so much higher.

This principle can be applied to the government’s debt. The United States government can get
into a massive pile of debt but then let inflation decrease the value of their currency so in the

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future the government will be paying back all that fixed-rate debt with money that is now worth
less. This is exactly what the U.S. did after World War II. The U.S. used inflation to reduce its
debt-to-GDP ratio. So explaining how this can potentially occur today can be done with money
printing by the Federal Reserve known as quantitative easing. So let's say the Federal Reserve
prints a lot of money and buys some government bonds. This increases the amount of U.S.
dollars existing and gives new money to the government to spend. Accordingly, this money will
be invested back in the economy be it through infrastructure, building more roads, or creating
more jobs, essentially increasing the productivity of the United States.

Thus as productivity rises, businesses and workers earn more, which leads to higher incomes and
more tax revenue, lower borrowing costs and increased investments, and increased asset prices.
Hence generally the inflation rate will pick up too and if this scenario continues, as years pass,
with the acceleration of the U.S. economy the increased GDP, and continued steady inflation, the
past debt will start to look smaller and smaller.

3. Impact on India’s Financial System and Dedollarization

a. Depreciation of the U.S. Dollar and Implications for India

The U.S. dollar often depreciates during periods of fiscal instability, such as the debt ceiling
crisis. For India, this depreciation can have mixed effects. A weaker dollar can make Indian
exports less competitive globally, which could contract trade in the short term. Moreover, a
depreciated dollar also means a devaluation of India’s foreign reserves, which are heavily
denominated in U.S. dollars. The decrease in value of the dollar may also lead to higher inflation
in India, particularly if crude oil prices, and necessary imports, (which are denominated in
dollars) rise. This in-turn would put pressure on India’s balance of payments and accordingly
will lead to monetary tightening by the Reserve Bank of India, further constraining economic
growth​or output.

b. India’s De-dollarization Strategy

India’s de-dollarization strategy is visible not only by adoption of the UPI(Unified Payment
Interface) or the BRICS currency. Furthermore, we see that the introduction of Special Vostro

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Rupee Accounts (SVRAs), established to facilitate trade in Indian rupees, represents a critical
part of India’s de-dollarization efforts. This initiative may allow India to bypass the U.S. dollar in
bilateral trade with countries like Russia, thereby reducing exposure to dollar volatility and the
Debt Ceiling crisis in the U.S. (Khandelwal, 2023).

Conclusion

We were able to reveal why the recent U.S. debt ceiling crisis serves as a wake-up call for the
global economy, urging countries to diversify their financial assets and safeguard their financial
systems against future shocks.

Future Scope of Research

By the end of this report, we see several promising avenues opening up. Firstly, the ongoing
analysis of de-dollarization efforts in emerging economies like India warrants more detailed
analysis and review of current and future potential actions. We see that an in-depth understanding
of India's initiatives, such as the adoption of Special Vostro Rupee Accounts (SVRAs) and its
collaboration with BRICS nations, could offer us insights into the broader global trend of
reducing dependence on the U.S. dollar and de-dollarize domestic economies. We also see that
investigating how other countries replicate or adapt similar strategies towards de-dollarization
can provide us with a comparative framework to better design monetary policies

Furthermore, research could focus on the detailed implications of using inflation as a strategy for
managing high levels of sovereign debt. The study could explore both the benefits and long-term
risks of this approach, particularly how inflation-driven policies might exacerbate economic
inequality or create disruptions in global trade. Given the global interdependence of financial
systems, an examination of collaborative international frameworks to stabilize global markets
amid U.S. fiscal instability is essential.

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