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What is the Debt Ceiling?

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Debt Ceiling 101

Once a little-known aspect of the U.S. government’s fiscal management process, the debt ceiling exploded into the public consciousness following the intense debate that took place in the summer of 2011. As its name would suggest, the debt limit is simply the maximum amount that the U.S. government can borrow at any given time.

Each year, the government spends more than it takes in, and this gap must be funded with debt, or more specifically, bonds issued by the U.S. Treasury. By law, however, the Treasury can’t issue new debt once the country is at its borrowing limit – and this limit, or ceiling, needs to be agreed to by Congress.

The debt limit doesn’t authorize new spending; instead, it provides the funding to pay for spending commitments that Congress has already made. The Treasury can’t issue new debt once the limit has been reached, but it can forestall a crisis for several months via stop-gap measures. Once these measures are exhausted, the government would be forced to slash spending - an outcome that could result in a partial government “shutdown” and/or a debt default (i.e., the failure to make interest and/or principal payments on time).

The Current Status of the Debt Limit

The limit is currently under suspension until March 15, 2015, based on a bill passed by Congress on February 13, 2014. The previous limit was $16.69 trillion, where it had stood since May.

Most estimates had the stop-gap measures that had been in effect previously lasting only February 27, 2014. That the agreement came 14 days ahead of the deadline represents an earlier solution than has occurred near past deadlines, when agreements typically were accomplished at the eleventh hour. One possible reason for this shift is that many Republicans worried that another round of debate on the debt ceiling would harm their party's image ahead of the 2014 congressional elections.

The debt ceiling has been a perpetual source of debate in recent years, but this agreement takes the issue off the table until early 2015. This a positive development for the financial markets, although not the health of the United States' finances.

Political Divisions Lead to Debate and Crisis

In the past, the process of approving increases was largely a formality that occurred frequently but took place outside of the public eye. More recently, however, the increasingly divisive political climate has prompted both parties to dig in their heels and fight for their core beliefs rather than seek compromise.

The political winds first began to shift in late 2010, when the Tea Party movement sent a wave of Republicans to Washington with a simple mandate: cut spending and reduce taxes. In mid-2011, Republicans resisted signing on to the usual debt-limit increase unless the Democrats agreed to future spending cuts.

While the debt-ceiling increase was eventually passed on August 2, 2011 – increasing the debt limit by $2.4 trillion following concessions by the Democrats to cut future spending – the debate continued right up until the deadline. The possibility that the government could default on its debt resulted in severe financial market volatility and ultimately prompted the rating agency Standard & Poor’s to strip the United States of its AAA credit rating.

While the compromise addressed the problem in the short term, the United States’ debt continued to grow so quickly that even the $2.4 trillion increase to the debt ceiling agreed upon in 2011 bought the U.S. government less than two years’ time. The government again hit the limit in February 2013, which at the time was $16.4 trillion. The limit was suspended for three months, during which time the debt rose to about $16.7 trillion. This became the new limit in a deal that Congress finalized in May, 2013.

The Implications of Exceeding the Limit

If, at any point, the United States is over the limit and the Treasury exhausts its extraodinary measures, the country risks defaulting on its debt - or more specifically, the payments the come due immediately after the point where the Treasury can no longer pay its bills.

For any developed market, and particularly for the United States – which has seen as having the safest bond market of any country in the world – a default is almost unthinkable. The result of this scenario, which has a very low probability of ever occurring, would be a large hit to economic growth and a substantial downturn across the global financial markets.

Why Have a Debt Limit at All?

Now that the debt ceiling is resulting in crises and roiling the markets, many critics are asking whether it’s necessary to have a ceiling at all. Indeed, the debt limit has done little to curb spending or reduce the debt, and it now appears to be doing more harm than good. Former Treasury Secretary Timothy Geithner has said the United States should “absolutely” abandon the debt limit, and that “The sooner the better.” It’s possible this will come up for debate in the months and years ahead, but for now investors need to stay focused on the climate in Washington and its implications for the current limit.

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