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What You Need to Know About the Debt Ceiling

Tuesday, 19 Jul 2011 08:50 AM

By Andrew Packer

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There’s a lot of opinion circulating about the possibility of a debt default. Although it’s currently estimated that the government has until Aug. 2 before it hits that point, the legislative deadline is currently at Friday, July 22. We asked members of our Financial Braintrust to chime in on what could happen, and answer a few basic questions about the debt ceiling for our readers.

What is the debt ceiling exactly?

The debt ceiling is a spending cap set by Congress on the level of debt the federal government can legally borrow. The limit was established in 1917 (at a mere $11.5 billion), and has been raised over 74 times since then, to current levels of $14.294 trillion.

Why is it important?

The debt ceiling was brought into creation under the theory that it would help Congress reign in spending, and that every time the limit was near, our national lawmakers would have to take a close look at the country’s finances and fiscal decisions.

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Since 1917, it has expanded to include the payment of unemployment benefits, Social Security, and all other types of spending by the federal government. So for millions of Americans dependent on this source of revenue, the debt ceiling talks are quite important.

At least in theory. After all, it’s been raised on 10 different occasions in the past 10 years. For politicians, however, votes on the debt ceiling are prime opportunities to appeal to their base.

Does it really matter from an economic standpoint, or is it just political grandstanding?

It’s a little of both — but mostly political grandstanding at this point, as has often been the case during prior debates about raising the debt ceiling.

During the debate to raise the debt ceiling in 2006, then-senator Barack Obama had this to say:

obama200getty.jpg
President Barack Obama
(Getty Images photo)
“The fact that we are here today to debate raising America's debt limit is a sign of leadership failure... America has a debt problem and a failure of leadership . Americans deserve better. I therefore intend to oppose the effort to increase America's debt limit.”

He subsequently voted against raising the ceiling. As president, however, Obama has called opposing a rise in the debt ceiling as dangerous.

What makes the current debate so contentious, however, are warnings from ratings agencies that US government debt could be downgraded from a near-riskless AAA rating.

What’s most likely to happen?

Dividend Machine editor Bill Spetrino sums up the most likely outcome from the debt ceiling debate:

“The debt limit will be raised. Democrats and republicans will agree to spending. Republicans do NOT want to take any blame for a government shutdown. They will tell tea party folks that they did the best they could for only controlling one house of Congress. This is all political theatre and the S&P should run once it’s all done.”

What if there’s no deal reached before the deadline?

If no deal is reached right away, there will be a partial shutdown. This will start with non-essential services, such as parks departments. Payment on programs such as Social Security and interest on the debt is expected to continue.

What’s the worst-case scenario?

In the worst case scenario, no compromise will be reached, ratings agencies will substantially downgrade US debt, and US government debt will lose its allure as a risk-free investment. This may cause a rally out of Treasuries into the dollar, other sovereign debt, or into precious metals such as gold.

Either way, the government will be spending billions of dollars per day and will not be able to borrow to make payments. That spells higher taxes or reduced government spending, most likely a combination of the two.

How does extending the debt ceiling solve America’s long-term fiscal problems?

It doesn’t. The debt ceiling has been raised on average once per year since 2001. It is simply raised to cover increased government spending.

Why are credit ratings agencies threatening to downgrade US debt if the debt limit isn’t raised?

Braintrust member Michael J. Carr notes:

“Because Dodd-Frank makes them. That law placed new requirements on Nationally Recognized Statistical Rating Organizations (NRSROs) and intends for them to become more forward-looking. These agencies completely missed warning on the financial crisis and now being vilified for that. They seem to be trying to get in front of any future train wrecks by downgrading sovereign debt early and often.

In part, it's an unintended consequence of a 2300 page bill that requires more than 60 studies and over 200 new rules.”

What does Obama mean when he says he can’t guarantee Social Security payments if the debt ceiling is breached? Isn’t there a trust fund for Social Security?

Braintrust member Andrew Packer says:

“Officially, Social Security revenues go into a trust fund. But in reality, that money gets spent on everything right away, from current Social Security benefits to federal salaries to highway funds and every other government expense under the sun. So, Obama is correct to say that he can’t guarantee Social Security payments, because the money technically isn’t there.

What is in the fund, however, are Treasury IOUs to the fund, which could in theory be cashed in. The fund still has a substantial surplus of these Treasury IOUs to draw down, so any threat is just designed to motivate politicians to arrive at a solution faster.“

How could we avoid future problems with the debt ceiling?

Dave Skarica writes:
“They should eliminate the debt ceiling. It is an exercise in futility.”

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