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Q&A About The Debt Ceiling and its Consequences


On May 16, 2011 the U.S. reached its debt limit of $14.3 trillion. With the subsequent possibility that the U.S. will be unable to issue further debt, and may even undergo a technical default, there has been a lot of discussion, and hype about raising the debt ceiling. You may be hearing mixed messages about the debt ceiling and the impact of default. Here are answers to some questions you may have about the debt limit.[i]

What is the Debt Limit?

The federal debt limit was created in 1917 with the passage of the Second Liberty Bond Act of 1917. The idea behind the debt limit was that it would give Congress the ability to oversee debt without having to approve specific loans from the public. Since the debt limit was introduced, it has been raised numerous times. It was raised each year from 1941 to 1945 to accommodate the costs of World War II, reaching $300 billion in 1945 before it was reduced to $275 billion. The limit was altered 9 times between 1945 and March 1962 when it again reached $300 billion. Since March 1962, Congress has enacted 73 measures that have altered the limit on federal debt, allowing it to reach its current level of $14.3 trillion.[ii] Although federal debt has reached its limit in the past, the Treasury has always been able to employ emergency techniques to meet financial obligations, and the debt limit has always been increased before the Treasury becomes unable to make payments.[iii]

Why the Recent Hype about the Debt Ceiling?

When the debt reaches its limit, the Treasury cannot issue new debt. The debt ceiling functions analogously to the spending limit on a credit card:  Once a card is “maxed out”, it is not possible to continue to use the card without first paying down some of the debt.  Without raising the ceiling, this presents a liquidity limit, and the possibility that until they collect taxes, the Treasury will not be able to meet its financial obligations.  When the Treasury is unable to finance its obligations it is called default. On May 16, 2011 the U.S. reached its debt limit of $14.3 trillion, and the Treasury began employing emergency steps to conserve cash and avoid default. It stopped issuing certain debt for state and local governments and stopped payments into the Civil Service Retirement system. According to Treasury Secretary Tim Geithner, emergency techniques will allow the Treasury to avoid a technical default until August 2, 2011.[iv] There has been significant political disagreement over the debt ceiling. House Republicans hold the opinion that reaching the $14.2 trillion debt ceiling is a signal that the U.S. needs to start significantly limiting spending. Republicans maintain that they will not accept a bill that increases the debt ceiling without significant spending cuts attached to it. While some Democrats want to raise the limit without spending cuts, many, including President Obama, agree that an increase in the debt limit should have spending cuts attached to it. The debate is mainly about how large these spending cuts will be.[v] On May 31, the House of Representatives held a symbolic vote on a bill that would increase the debt ceiling without cutting spending. All House Republicans and about half of House Democrats voted against the bill, declaring that an increase must come with significant deficit reduction. The Administration is currently in negotiations with Congressional leaders to reach a bi-partisan deal that will both raise the debt ceiling and cut spending. Most experts remain hopeful that a deal will be reached.  

What if the U.S. Treasury Defaults? 

If a deal cannot be reached, the US Treasury may go into what is referred to as a technical default.  While a technical default is not necessarily as severe as a “real” default, it does not reflect positively on the America’s fiscal policy, political will, and ability to make necessary cutbacks.  Stanley Druckenmiller, a well-known investor and previous fund manager for George Soros, holds the opinion that it will be much more catastrophic to the economy if the U.S. does not stop incurring debt at its current rate than if the U.S. defaults on its debt. "I think technical default would be horrible," Druckenmiller says, "but I don't think it's going to be the end of the world. It's not going to be catastrophic. What's going to be catastrophic is if we don't solve the real problem [of government spending]."[vi] Druckenmiller and other experts hold that while most investors have faith that the debt ceiling will ultimately be increased, many do not have faith that the long-term debt crisis will be sorted out.[vii] There is reason to believe that a short-term delay in interest payments will not cause investors to lose faith in the Treasury as much as continued, irresponsible borrowing and spending will. That being said, the Treasury, Congress, and the President should attempt to avoid default. The best case scenario for investors will be if significant spending cuts are enacted and the U.S. avoids default.



[i] The Debt Limit: History and Recent Increases.  CRS Report for Congress.  April 29, 2008.  Retrieved from: http://fpc.state.gov/documents/organization/105193.pdf

[ii] Ibid.

[iii] Ibid.

[iv] “Timothy Geithner Meeting with Republican Skeptics on Debt Ceiling”. Huffington Post. June 2011. Retrieved from:  http://www.huffingtonpost.com/2011/06/02/timothy-geithner-debt-ceiling_n_870182.html

[v] “Republicans Press Obama for Plan on Spending Cuts”. BBC News. June 2011. Retrieved from: http://www.bbc.co.uk/news/world-us-canada-13619249

[vi] Freeman, James. “What Happens if the U.S. Treasury Defaults?” Wall Street Journal. May 2011. Retrieved from: http://online.wsj.com/article/SB10001424052748703864204576317612323790964.html

[vii] Ibid.