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What You Need to Know About the Debt Ceiling

The debt ceiling, originally conceived as a tool to control government spending, has failed to do so. What it has succeeded in doing is introducing uncertainty into markets, raising borrowing costs, and serving as a tool for parties to introduce their preferred spending policies, all too often to the detriment of ordinary households.
The National Debt Clock

New York NY USA-May 17, 2023 The National Debt Clock in the AnitaÕs Way arcade in Times Square in New York © rblfmr/

June 07, 2023 22:13 EDT

The recent debate surrounding the US debt ceiling has evoked widespread concern and uncertainty. However, with the signing of a bill by President Biden on June 3rd, the debt limit has been temporarily suspended until January 2025, averting the immediate threat of a debt default. Despite this temporary relief, important questions persist regarding the purpose and effectiveness of the debt ceiling. This article aims to provide a comprehensive understanding of the US debt ceiling, its historical context, and the implications and challenges associated with its existence.

The debt ceiling in the United States originated from the need to control government spending and ensure fiscal responsibility. Initially, Congress had to authorize each new batch of debt issued, a cumbersome process that was modified with the passage of the Second Liberty Bond Act of 1917. This act established an aggregate amount, or debt ceiling, to govern the total debt to be issued. Since World War II, the debt ceiling has been adjusted over 100 times to accommodate the country’s evolving financial needs.

The concept of a debt ceiling, however, itself poses logical inconsistencies. All federal government spending is already authorized by Congress, making it contradictory to prevent the Treasury Department from raising the necessary debt to fund these authorized expenditures. In other words, Congress forbids spending which it has already mandated. Reaching the debt limit forces the government to choose between not fulfilling previously agreed obligations or defaulting on existing debt service. Either of these would be a violation of obligations established by law, and would therefore have severe implications for the US economy.

Implications of reaching the limit

Reaching the debt ceiling carries significant implications for the US economy. It can lead to a government shutdown, disrupt essential services, and even result in default on financial obligations, jeopardizing the nation’s creditworthiness. Credit rating agencies closely monitor debt ceiling debates. If they were to downgrade the federal government’s credit rating, this would increase borrowing costs and undermine investor confidence. Uncertainty surrounding the debt ceiling, even if it is not eventually reached, also introduces volatility into financial markets and can impact global economic stability.

Government default entails the non-payment of interest or principal on its obligations. This triggers a credit event that has far-reaching consequences. Individuals and institutions relying on government funds would not receive payments. Credit default swaps (CDSs)—insurance contracts taken out against credit events—would be triggered, potentially causing financial difficulties for institutions which have written CDSs. Rating agencies would downgrade the US credit rating, impacting other borrowers, and Treasury securities would no longer serve as acceptable collateral for institutional borrowing, leading to a collapse of credit availability, choking the economy and leading to a severe contraction.

Rating agencies such as Fitch and Standard & Poor’s have expressed concerns about the United States’ credit rating, despite the recent agreement on the debt ceiling. A potential downgrade could have implications not only for the US but also for all other borrowers whose credit rating is usually influenced by the sovereign rating. With the US bond market dominating global markets, the loss of the anchor role of US Treasuries, which form a substantial part of institutional portfolios worldwide, could create disarray in international bond markets.

Partisan shenanigans and a borrowing spree

The debt ceiling has become a contentious political issue in recent decades, with both major parties sharing responsibility for substantial increases in outstanding debt. The threat of a debt default has often been used as a bargaining tool in political negotiations. However, neither party wants to bear the blame for driving the country into a crisis, resulting in a risky game of chicken in which each party attempts to see who will budge first and agree to concessions favorable to the other party’s spending policy. This raises questions about whether the debate really revolves around the debt itself. The recent deal, featuring a suspension of the debt limit, essentially provides the Treasury the freedom to borrow as much money as needed until January 2025—a carte blanche.

The government’s account at the Federal Reserve, the Treasury General Account (TGA), has almost been depleted. It will have to be replenished to 600 billion US dollars (it peaked at 1.8 trillion US dollars during the pandemic). Those funds will have to be raised by raising additional debt—on top of money needed to fund the current federal fiscal deficit of around 2 trillion dollars. As I mentioned in a previous article, it is not apparent who would buy that amount of Treasury securities. The Federal Reserve might be forced to reverse its plan to slowly shrink its balance sheet, having to absorb additional government debt.

After borrowing 726 billion dollars during the second quarter of 2023, the Treasury Department expects to raise another 733 billion dollars in the following quarter. Total government debt is hence guaranteed to continue rising at a fast pace. Having briefly been arrested at 31.4 trillion dollars (the amount of the debt ceiling), federal debt is expected to exceed 50 trillion dollars by 2033. The exponential growth of government debt is going to continue unabated.

The spending bill includes some mild cuts of non-military discretionary spending in 2024, and a limit of all discretionary spending in 2025. Military spending, however, will increase further, to 886 billion US dollars in 2024, and 895 billion in 2025, a 23% increase over the amount spent in 2022.

The bill’s drafters found other devices to cut costs. 20 billion dollars originally awarded to the IRS (Internal Revenue Service) to fight tax evasion will be clawed back. The bill imposes new requirements for adults to maintain access to food stamps. It also ends the freeze on student loan repayments. In short: money taken from the poor is being given to the military and to people crafting “innovative” tax returns.

Hidden under the surface-level negotiations was a fight over permit reform. Local governments had the ability to block interstate pipelines and electricity lines by dragging out the permitting process. Alternative energy companies need new transmission lines to transport energy produced by wind and solar farms towards population centers near the coasts. Fossil fuel companies need pipelines to move abundant natural gas from sparsely populated areas with shale reservoirs towards the big cities or harbors for export. In the end, the Mountain Valley Pipeline, bringing natural gas from the Marcellus shale fields in West Virginia to Virginia, made it into the bill, securing Senator Joe Manchin’s vote.

A proposal to end recurring debt ceiling drama

US lawmakers recognize the insanity of recurring debt ceiling debates, especially since it is a question of funding spending that has already been authorized by Congress once.

One option contemplates a bureaucratic rather than a legislative solution. This would involve the Treasury Department disregarding the debt ceiling and continuing to issue debt. The perspective finds support in the 14th Amendment of the US Constitution, which states that “the validity of the public debt of the United States, authorized by law…shall not be questioned.” However, pursuing such a unilateral move could result in a legal dispute and potentially generate still more uncertainty.

Another suggestion entails the Treasury minting a platinum coin with a denomination of 1 trillion US dollars, as it is legally permitted to do. This coin would then be deposited with the Federal Reserve in exchange for a credit of 1 trillion dollars. However, Treasury Secretary Yellen has dismissed this idea, noting that the Federal Reserve is unlikely to agree to such a proposal.

It is worth noting that the US government has in fact experienced instances of default in the past. Esteemed Wall Street veteran Jim Grant argues that a default can occur through a unilateral change in payment terms, resulting in a diminished financial obligation, such as forced currency redenomination. Two events over the past century align with this definition. Firstly, the devaluation of the dollar relative to gold under US President Roosevelt in 1933, when the gold price was raised from $20.67 to $35 per ounce. Secondly, the “temporary” suspension, which has since become permanent, of the dollar’s convertibility into gold by US President Nixon in 1971.

In reality, persistent inflation can be viewed as another form of default, albeit spread out over many years. Over time, the US dollar has lost approximately 97% of its purchasing power since the establishment of the Federal Reserve in 1913. While the dollar remains an effective medium of exchange, it has proven to be a poor long-term store of value due to the erosion of its purchasing power through inflation.

If spending is not controlled, the government will find one way or another of making ends meet, and all too often it is the consumer who foots the bill.

[Anton Schauble edited this piece.]

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.


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