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 current limit is $16.69 trillion, where it has stood since May.
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).
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. This only repre another short-term "solution," however, and the Treasury has since been operating under stop-gap measures.
The Current Status of the Debt Limit
The most recent crisis occurred in October 2013, when the two sides again waited until the last minute to reach a deal just days before the Treasury was set to run out of options to continue paying the nation's bills on October 17. Congress voted to suspend the debt ceiling until February 7, which provides the Treasury with the ability to start with a new set of stop-gap measures to continue its operations. Between now and February 7, the debt will rise by as much as the government spends over its receipts. The agreement also established a committee to develop a plan for deficit reduction by December 13.
This deal, while removing the near-term threat of a default, largely represented a short-term solution since it only "kicked the can down the road" without offering a more meaningful plan for longer-term debt reduction. Although the debt ceiling is out of the headlines for now, expect to hear more about this issue in 2014.
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. 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.