What Is the Debt Ceiling (And Does It Matter)

On Thursday, January 19, 2023, Treasury Secretary Janet Yellen announced that the United States had hit its debt ceiling of $31.4 trillion and is now relying on “extraordinary measures” to continue paying its bills. These measures should carry the U.S. through early June, at which point the government risks default if lawmakers can’t reach a deal to raise the national debt limit.

 

Defaulting could have potentially disastrous consequences for the U.S. economy, such as higher interest rates, job losses, and a decline in GDP. It could also negatively impact those who rely on government benefits and services.

 

Indeed, this is not the first time the U.S. has reached its debt limit. Nor is it the first time Congress has used it as a bargaining chip.

 

In 2011, the U.S. got dangerously close to defaulting on its debt, leading Standard & Poor’s to downgrade the country’s AAA credit rating for the first time ever. As a result, markets plummeted, interest rates jumped, and the country’s borrowing costs increased by $1.3 billion.

 

Now, U.S. lawmakers are locked in a political stalemate as they debate raising the debt ceiling once again. Meanwhile, the economy hangs in the balance.

 

As we watch the drama unfold, here’s what you need to know about the U.S. debt ceiling.

 

What Is the Debt Ceiling?

 

When the government's expenditures exceed its revenues, it must borrow money to finance the deficit. It primarily does this by issuing U.S. Treasury securities, which are available for the public to purchase. Most U.S. government bondholders are U.S. citizens.

 

Congress established a national debt limit in 1917 by passing the Second Liberty Bond Act. Prior to this legislation, Congress had to approve each new issuance of debt individually.

 

The debt ceiling simply limits the amount the federal government can borrow and represents spending that Congress has already authorized. Raising this limit does not necessarily mean government spending will also increase. In many cases, Congress has attached debt ceiling increases to budget cuts and other legislation to reduce the deficit.

 

Why Does the Debt Ceiling Keep Increasing?

 

The national debt accumulates over time due to recurring budget deficits and interest expense on existing debt obligations. When it hits the debt ceiling, the federal government can no longer legally borrow money to finance its obligations.

 

However, the Constitution gives Congress the power to raise the country’s debt limit, which it has done 78 times since 1960. For context, since the 1980s Congress has increased the debt ceiling from less than $1 trillion to over $31 trillion today.

 

In fact, Congress has never not voted to increase the debt ceiling when the government reaches its limit. Yet lawmakers often use it as a reason to negotiate other issues before agreeing to move forward.

 

Why Is Congress in a Standoff Over the National Debt?

 

This is the first time the U.S. government has reached its debt limit since Republicans took control of the House of Representatives in the November mid-term elections. Thus, Republicans are using it as an opportunity to push for spending cuts before agreeing to raise the debt ceiling.

 

It’s still unclear where and how spending would be cut. However, Republicans say that the debt is spiraling out of control due to inflation, rising interest rates, and constant budget deficits. According to the Congressional Budget Office, the interest expense alone on the national debt will be $2.5 billion more over the next decade than they previously expected.

 

Across the aisle, Democrats argue that the national debt is due to revenue problems—not overspending. They point to past tax cuts under Presidents Reagan, Bush, and Trump, which coincided with greater budget deficits.

 

Meanwhile, President Biden has said that there won’t be any negotiations because Congress has a duty to pay its bills. Yet given a split Congress, both parties will ultimately need to agree on a path forward.

 

What Happens If Congress Doesn’t Raise the Debt Limit?

 

Put simply, the U.S. government’s failure to meet its financial obligations could have dire consequences at home and globally.

 

Indeed, even the threat of default can send the economy and financial markets into a tailspin. In 2011—the last major national debt standoff—the U.S. came within 72 hours of defaulting on its debt. Meanwhile, the stock market lost 7% in one day after Standard and Poor’s downgraded the United States’ credit rating on the mere possibility of default.

 

If the U.S. were to default on its debt this time around, it could affect consumers and investors in a variety of ways. For example:

 

·         Federal benefits could be frozen. Social Security, Medicare and Medicaid, Veterans benefits, and more could be frozen immediately.

·         Borrowing costs are likely to rise. If investors view the United States as a credit risk, interest rates on Treasury bonds and other debt instruments will increase to account for this risk. Consequently, everything from mortgage rates to interest rates on small business loans would likely increase if the U.S. were to default on its debt.

·         The economy could go into recession. As the federal government cuts benefits and borrowing costs rise, consumer spending is likely to fall, thus negatively impacting GDP.

·         Stock market volatility may spike. In the near term, uncertainty surrounding the debt ceiling may cause markets to fluctuate. Longer-term, the economic damage resulting from a default could be devastating for the market.

 

Lastly, investors may need to rethink their asset allocations if the U.S. defaults on its debt. For many long-term investors, U.S. Treasury securities are the safest part of their portfolios given their near-zero default risk. This may no longer be the case if the full faith and credit of the U.S. government is compromised.

 

What Happens Next?

 

Although it seems unlikely that Congress will default on its financial obligations, dragging negotiations out until June could also be costly. It’s up to lawmakers to reach a compromise and forge a path forward.

 

One thing we do know is that markets dislike uncertainty. Therefore, volatility is likely to continue in the meantime.

 

It’s also important to remember that we’ve been here before. While 2011 was painful for many investors, markets eventually recovered to reach new highs. If history is a guide, there’s no reason to believe this time will be different.

 

We continue to believe that long-term investors will be best served by sticking to your financial plan. If you don’t have a financial plan, we’re here to help. Please contact us to schedule an introductory meeting.