A unique rule in America’s fiscal system means that the world’s largest economy is about to run out of money.

US lawmakers have been arguing over whether to raise or suspend the so-called “debt ceiling”, which determines how much money the US government can borrow.

Treasury Secretary Janet Yellen has warned that if an impasse between Republicans and Democrats is not broken, the administration will not have enough cash to pay its debts as early as June 1.

The political stalemate over increasing it is deepening. If it is not resolved, there is a looming risk that the US government could default on its debt.

The repercussions would be global and ruinous. “That is when you’re into a genuine potential financial market catastrophe situation,” says Andrew Hunter, deputy chief US economist at Capital Economics.

What is going wrong and how bad could it get?

What is the US debt ceiling?

Since 1917, the US has had a law that sets a statutory limit on the total amount of debt that the Government is allowed to have. The limit was first set at $11.5bn (£9.2bn).

The ceiling is a little similar to the fiscal rules that the Chancellor sets himself in the UK, but it is set externally. “The key problem is that it is treated completely separately to the decisions on how much the government should spend and what level taxes should be,” says Hunter.

Congress passes new spending bills that will increase the debt level, but the debt ceiling is not raised until it is about to be breached.

The figure was also set as a blanket cash figure, which does not automatically change to reflect factors such as population growth or inflation, acting as a kind of gastric band.

American government debt has increased under every single president since Herbert Hoover. In response, the debt ceiling has been raised more than 100 times. It now stands at $31.4 trillion.

US government debt hit this level in January, which means that the Government cannot legally borrow any more money.

Why hasn’t the debt ceiling been increased?

The debt ceiling can be raised again, but only if it can be voted through the House of Representatives, which has a Republican majority. When the ruling party does not have a majority in the House – as is the case with the current administration – there is no guarantee that an agreement will be met.

The Republicans are trying to use the deadline to pressure President Joe Biden to agree to spending cuts. On April 26, the House approved a bill to raise the debt limit by $1.5 trillion, but only on the condition that spending would be cut to 2022 levels and then capped at 1pc growth per year. It is not expected to not pass through the Senate, which has a Democrat majority.

There is a political stalemate, which means the future of the American economy is in purgatory. If an agreement cannot be reached quickly, there may be explosive results.

What happens if the debt ceiling cannot be raised?

The US government runs a deficit, which means it spends more money than it collects in tax.

This means two things. First, the size of its debt increases every year, and therefore so do the costs of servicing it. Second, if it cannot borrow any more money, the Government will stop being able to cover all of its costs.

The US Treasury’s cash balance at the end of April was $316bn. “The question is when will that cash run out?” says Hunter. Treasury Secretary Janet Yellen says it will in June.

When this money has run out, the Government will only be able to spend the money that it receives in tax. It will therefore no longer be able to meet all of its public spending obligations, such as paying public sector salaries, or service all of its existing debt.

Treasury bonds due in June might not get repaid. This could trigger a financial crisis, says Hunter.

What would happen if the American Government defaulted on its debt?

In theory, if America defaults on its debt, this would send the value of its government debt into turmoil.

The majority (69pc) of US debt is held within America. The Federal Reserve holds 21.2pc, 12pc is in pensions or mutual funds, while US households own 6.7pc.

A further 31pc is foreign-owned. Japan is the largest holder of US Treasury securities, with around $1.1 trillion. China and the UK hold $867bn and $654bn respectively.

But if America defaults, the repercussions would potentially be far larger.

“US Government debt is basically considered the single safest asset in the financial system, and there is a lot of it as well. As a result, a very significant chunk of the price of every other financial asset out there is in some way derived from the price of US government debt,” says Hunter.

If the US defaults, there would be a large spike in borrowing costs in America that would in turn trigger a corresponding rise in borrowing costs around the world, says Hunter. 

“Basically, suddenly, every safe asset will suddenly look a lot less safe than it previously did. If that is suddenly at risk of being defaulted on then basically all bets are off in terms of what is going on in wider financial markets,” he adds.

“Failure to reach an agreement at all would bring more severe macroeconomic dislocation given the current scale of the Federal budget deficit and the actions needed to close this quickly,” the Organisation for Economic Cooperation and Development has warned.

A man-made problem

But questions remain over how investors would view a default due to the debt ceiling, because the problem would be entirely man-made. 

“The big difference between a potential default resulting from the debt ceiling compared to, say, a default in a country like Argentina which has defaulted loads of times throughout history, is that this would be possibly the only time a country has ever defaulted on its debt essentially out of choice rather than out of economic necessity,” says Hunter.

There is no suggestion that America cannot afford to keep paying its debts, but the Government will be bound by law. “It has created a sort of artificial risk of default,” says Hunter.

America has been even closer to the deadline in the past. Back in 2011, the agreement was passed on the day that the Government was due to run out of money. There was another close shave in 2013.

Previously, when the Government came close to running out of money, although interest rates on Treasury bills that were due to expire jumped, the yields on 10-year Treasury bonds actually fell sharply. “Even with the deadline so close, people still weren’t really thinking there was a genuine chance that the US government would suddenly stop repaying all of its debts,” says Hunter.

The issue was more one of short-term disruption. Longer-term yields fell back, likely on the expectation that interest rates would have to remain lower for longer because of economic weakness and uncertainty, says Hunter.

But the stakes are higher this time. Back in 2011, federal debt was 65.8pc of American GDP. Now, it is 98pc. Interest rates are also much higher. Both of these factors together mean the Government faces much higher debt servicing costs. “In terms of the sustainability of US government finances, this situation is even worse than it was 10 years ago,” says Hunter.