As Senate leaders attempt to craft a last-minute compromise on the debt ceiling that would avert a government default, Associate Professor of Economics Tara Sinclair answers questions about the debt ceiling and the consequences for both the nation at large and individual Americans if Congress fails to raise it.
Q: How did the debt ceiling come to be?
A: The debt ceiling comes from a federal law that was first passed in 1917. It was originally designed to make it easier for the U.S. to borrow in World War I by making it easier for the Treasury to sell bonds. Before 1917 Congress had to approve every bond sale. Now they allow the Treasury to handle the bond sales and only revisit the issue when they reach the most recent cap Congress has set on total outstanding debt. Congress regularly has to vote to raise the U.S. debt ceiling, and it has become a time to recognize the impact of budget deficits that add to the national debt.
Q: What will happen if Congress fails to raise the debt ceiling?
A: If Congress does not increase the debt ceiling, the Treasury will be unable to borrow funds beyond the cap, which is currently set at $16.699 trillion. Even with the government currently shut down, bills are coming in that Congress had previously committed to pay, but there isn’t going to be enough money coming in to cover them all. Therefore, the Treasury needs to borrow funds by selling bonds, but we’ve already reached the cap so Treasury isn’t authorized to borrow any further funds. This means that in order to fulfill previously made obligations the debt ceiling has to be raised. Otherwise, the government will not be able pay all the bills coming in.
According to the Treasury, to avoid exceeding the debt ceiling, they will soon need to cut or delay payments for things like Social Security, Medicare, government and military salaries, and many others. In a worst-case scenario they may not even be able to pay the interest on the national debt. This would lead to a full-fledged default. In this case, the U.S. would no longer be considered trustworthy to fulfill their financial obligations, making future borrowing, even just to roll over existing debt as bonds mature, much more expensive. The Treasury would therefore have to pay higher interest rates to entice people to buy the bonds that would now be considered much more risky. In fact, even just not paying other obligations while still paying interest on the debt will probably nevertheless affect the perceived creditworthiness of the U.S. and push interest rates up substantially.
Q: How did the U.S. government get to this point?
A: Every time Congress passes a budget in which spending will exceed revenues (i.e., a deficit), it is deciding to increase borrowing and therefore add to the government debt. Budgets over the past several years have included substantial deficits, in large part because of the recent recession – tax revenues were lower than usual due to lower employment and reduced economic activity and spending was up both from the stimulus package and because of increased demands on government programs like unemployment insurance. Furthermore, there has been little increase in the debt ceiling since 2011 to accommodate the increased borrowing by the government. In fact, the debt ceiling was set at the amount of the debt the government had outstanding on May 18, 2013, so the Treasury has been using “extraordinary measures” to avoid borrowing further, but that can only last so long, and they will soon be out of options.
Q: Why are we at such an impasse?
A: There appears to still be some confusion in the public about what raising the debt ceiling means. It does not mean increasing spending. Congress authorizes spending through the annual budget. At this point we need to raise the debt ceiling just to find the funds already essentially spent. Even if the debt ceiling is raised substantially, government spending is determined by the budget, not by the amount of borrowing left below the latest debt ceiling.
In the past, the debt ceiling debates have sometimes been used to discuss longer-term spending plans, but the idea that the debt ceiling might actually not be raised in time to fulfill commitments that have already been made is a new, and much more risky, situation.
Q: What are possible consequences for defaulting?
A: A default of any sort would be disastrous for both the U.S. and the rest of the world. The first impact would be that interest rates would rise substantially. Higher interest rates would make it more expensive for everyone to borrow. Business loans would be more costly so firms would cut projects and jobs, mortgages would be more expensive at a time when the housing market is still weak, personal loans and credit cards would be more difficult to get exactly when households might need them most to weather the economic difficulties, etc. Because the rest of the world relies on the U.S. to be a safe place to put its money, a default would likely also bring about another global financial crisis.
Q: Would a default affect the average American?
A: Yes. The average American would see his or her interest rates go up on mortgages, car loans, student loans, credit cards, etc. Many people would also likely lose their jobs as firms would find it more expensive to borrow. Taxes would likely also have to rise because the government would be paying substantially higher interest rates on existing debt.
Q: What are the major points of disagreement between the Republicans and Democrats?
A: There are important debates to be had about the best way to reduce the growth of government debt. The Republicans have emphasized reducing spending, whereas the Democrats also want to find a way to increase revenue. The economic evidence is mixed as to what works best. There is also a question of when the government should focus on debt reduction. Some economists argue that the economy is still weak right now so it might not be the right time to reduce government spending or raise taxes. The U.S. government, however, cannot continue to grow the debt at the rate it is currently forecast to grow. This means that a reduction in spending, an increase in revenues, or some combination will be necessary in the near future.
Q: We had a similar situation in 2011 when the country came close to defaulting. Is this something we can expect to happen every few years?
A: Debate in Congress over the debt ceiling has been a regular occurrence since at least the 1960s. It is a useful way to recognize that budget deficits result in increases in government debt. Recently however, the sense of brinksmanship has increased as some members of Congress appear genuinely willing to risk defaulting on their obligations. So far, they seem to have gotten away with it, which may explain the closer approach to the edge in recent years. The problem is that our creditors might lose trust in us at any time, and, therefore, just the threat of default might be enough for interest rates to increase substantially. This would cause dramatic harm to the U.S. economy.