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 limit is currently set at $16.394 trillion, but the ceiling is under temporary suspension until May 18, 2013, following a bill passed on January 23, 2013. The debt ceiling will go back into effect on May 19, at which point the Treasury will begin funding the debt through late summer via stop-gap measures. For example, AP reported that the Treasury would temporarily suspend the sale of bonds to state and local governments on Friday, May 17.
Measures such as this can keep the goverment afloat for several months. However, the Bipartisan Policy Center - a Washington think tank that tracks the Treasury's cash flows - is estimating that the Treasury will run out of cash at some point between mid-August and mid-October, meaning that the issue will need to be addressed again at some point in the summer. Prior to that time, there is certain to be plenty of debate regarding how much spending needs to be cut, and from what areas.
The Implications of Exceeding the Limit
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 about one to two 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 a debt default (or the failure to make interest and/or principal payments on time).
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 low probability of occurring, would be a large hit to economic growth and a substantial downturn in the financial markets.
Political Divisions Lead to Debate and Crisis in 2011
In the past, the process of approving increases has largely been 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 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.
The Fiscal Cliff and the Next Debt Ceiling Debate
While the compromise solved the problem in the short term, two issues resulted from the agreement.
First, the automatic spending cuts that were part of the final 2011 agreement were scheduled to go into effect on January 1, 2013. The combination of these spending cuts, together with the tax increases that were to go into effect on the same day, were dubbed the “fiscal cliff” since the combined impact of the laws would have had an enormously negative impact on the U.S. economy. Congress came to an agreement regarding the fiscal cliff on January 1, 2013, which raised taxes modestly but delayed dealing with the spending cuts for an additional two months.
Learn more: What is the fiscal cliff?
The second issue is that 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. According to outgoing Treasury Secretary Timothy Geithner, the United States again hit the debt limit on December 31, 2012. This was addressed via the suspension of the ceiling that was enacted on January 23, 2013.
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 what it means for the May deadline.