One of the unique features of US fiscal policy is the concept of a “debt ceiling”. This term, which often arises in economic and political discussions, has profound implications for the US government and its financial obligations. The US debt ceiling is a legislative limit on the amount of national debt the US Treasury can incur, thus limiting how much money the federal government may borrow. The US Congress sets the debt ceiling.
The ceiling covers debt owed to the public (that is, anyone who buys US bonds) and debt owed to the federal government trust funds such as those for Social Security and Medicare.
When the government’s expenditures exceed revenues, it borrows to make up the shortfall. Consequently, the national debt grows. If the debt ceiling is hit, the Treasury Department can’t issue any more Treasury bonds, so it can’t borrow any more money. Suppose the government’s income isn’t sufficient to pay its bills (interest on the Treasury bonds and any other debt, principal payments on the Treasury bonds, Social Security payments, military salaries, income tax refunds, etc.). Such a case will result in a default.
A default by the US government on its obligations is considered a severe global economic event because US government debt is regarded as one of the safest avenues of investment in the world, often referred to as “risk-free” securities.
Thus, the debt ceiling has been a political issue because raising the debt ceiling means essentially allowing the government to tag along more debt, which might be viewed unfavourably, especially by fiscal conservatives. However, not raising the ceiling could lead to a default, with potentially severe economic consequences. Hence, Congress often has a contentious debate whenever the debt ceiling needs to be increased.
The debt ceiling serves as a reminder of the need for careful fiscal planning and responsible governance.
Historical context of the US debt ceiling
The US Congress established the debt ceiling during World War I. Before 1917, Congress approved every issuance of US debt. However, to provide more flexibility to finance the war effort, Congress introduced the Second Liberty Bond Act, which set an aggregate limit on federal debt. This act effectively formed the basis of the modern debt ceiling, allowing the US Treasury greater leeway in managing government debt.
Over time, Congress has raised or suspended the debt ceiling numerous times. As a result, the US has never defaulted on its debt obligations. Still, the risk of default has been a genuine concern during periods when the debt limit was reached and political wrangling delayed raising the ceiling.
It’s crucial to note that raising the debt ceiling doesn’t authorise new spending. Instead, it allows the Treasury to borrow money to pay for government spending that Congress has already approved.
Debate around the US debt ceiling
The US debt ceiling has been a subject of ongoing political debate. Those favouring a high or unlimited debt ceiling argue that meeting the government’s obligations and maintaining the nation’s fiscal health is necessary. In addition, they point out that Congress already approved the expenditures causing the deficit when it passed the budget, making it somewhat illogical to refuse to finance these decisions.
- Increased government spending: Some critics argue that continuously raising the debt ceiling enables excessive government spending. They believe they can force a conversation about reducing the government size and cutting spending by opposing the raising of the debt ceiling.
- National debt concerns: The US national debt is at historic highs. Those opposed to raising the debt ceiling argue that the country’s debt trajectory is unsustainable and could lead to serious economic consequences down the line, including potential inflation, higher interest rates, and decreased economic growth.
- Fiscal responsibility: Critics often use the debt ceiling to advocate for greater fiscal responsibility. They argue that the government should balance its budget just like households and businesses are expected to do.
- Political leverage: The debt ceiling can be used as political leverage. Lawmakers who oppose raising the debt ceiling might do so as a strategic move to obtain concessions on other legislative matters.
- Future generations: Some opponents of raising the debt ceiling express concern about passing on a significant debt burden to future generations. They worry that today’s borrowing could lead to higher taxes and lower living standards for those who follow.
Implications of a US default
- Delayed or missed payments: The most immediate impact on bondholders would be that the US Treasury might delay interest payments or even fail to repay the principal on its bonds when due. This directly affects investors who rely on these payments for income.
- Decreased value: The market value of Treasury bonds could fall. In the event of a default, the perceived risk of US government bonds would increase, which would likely drive down the price of these bonds in the secondary market.
- Increased yields: As bond prices decrease, the yields on these bonds (interest payments relative to the market price) would increase. This means new investors could buy US government debt at a higher yield, but existing bondholders who bought at lower yields would face losses if they sell.
- Eroded confidence: US government debt is considered one of the safest investments in the world, often referred to as “risk-free” securities. A default could erode confidence in the US government’s creditworthiness, making investors less willing to buy Treasury bonds in the future. This could make borrowing money more difficult and expensive for the US.
- Ripple effect: Given the central role of US Treasury securities in the global financial system, a default could trigger a financial crisis. This could affect bondholders, the broader financial markets, and economies worldwide.
The debt ceiling debates can create some uncertainty, though the US has never defaulted on its debt obligations. The US Treasury has always eventually been able to make all payments on its debt, often due to eleventh-hour political agreements to raise or suspend the debt ceiling.
Alternatives to not raising the US debt ceiling
- Treasury cash balance: The Treasury can draw down its cash balance to continue making payments. However, this is a short-term solution as the cash balance would eventually be exhausted.
- Asset sales: The US government could decide to sell assets (like gold reserves, government-owned real estate, or entities like the Tennessee Valley Authority). However, such sales could be complex, time-consuming, and potentially politically controversial.
- Expenditure cuts: The government could cut spending drastically to match its income. However, this could have severe economic effects and might still be insufficient to avoid increasing the debt.
- Suspension of debt issuance: The Treasury can suspend the issuance of specific types of debt, such as State and Local Government Series (SLGS) securities. SLGS are special-purpose Treasury securities issued to state and local governments, typically to help them comply with specific tax rules. Suspending their issuance doesn’t affect existing debt but slows the growth of new debt.
Each measure involves downsides, and none can substitute for a long-term solution to the federal government’s fiscal challenges.
Debt ceiling in other countries
Very few countries have a debt ceiling similar to that of the United States. Many countries, including those in Europe, have rules or guidelines about budget deficits and debt levels, but these typically work differently from the US debt ceiling.
Denmark is one example of a country with a debt ceiling. In most other countries, the legislative body approves borrowing as it approves spending, so there’s no separate process to authorise debt issuance. This approach avoids a situation where the government has committed to certain expenditures but cannot borrow the money needed to make those expenditures. This is the situation that can occur in the US when the debt ceiling is not raised.
Germany does not have a debt ceiling like the US. Instead, it has a “debt brake” that is enshrined in its constitution. The rule allows the federal government to run a structural deficit of no more than 0.35% of GDP in a year. The rule can be suspended during a crisis, such as a natural disaster or harsh economic downturn.
Switzerland has a debt brake rule too.
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