Over the past two years, there has been a lot of discussion about the debt ceiling after it was raised in 2021 and now in 2023 too. Here we have explained what the debt limit is, how the ceiling works, and the consequences of failing to keep debt below that agreed upon ceiling.
The Debt Limit Explained
Before we start, this topic can get quite complicated so here are the basics. The US’ expenditure dwarfs what it takes in from taxes, which is the same for many other countries around the world too. However, America does it the best, as you can imagine. This means that the government borrows money to stay functional, gathering debt.
This debt is managed by Congress and affected by wider market activity, especially in the bond market. Using the economic calendar this week, it’s easy to find upcoming dates that may help or hinder the country’s debt situation. If the debt is a useful metric to gauge the health of a nation’s economy, the calendar gives citizens an insight into the events that make it tick.
While debt may be a dirty word for individuals, most nations operate their economies based on fractional-reserve banking and the sale of stable government debt as a financial asset – treasury bills and bonds. Fractional reserve means that banks don’t have money to satisfy all deposits if a bank run were to occur, instead issuing credit to provide liquidity for an economy that needs to operate quickly and efficiently.
The Debt Ceiling & Why It Matters
So that’s a basic rundown of the debt limit. The debt limit is kept in control by the debt ceiling, which is decided by Congress. The first ceiling was established in 1917 and since then, it has been nudged upwards over one hundred times. In economically turbulent times, the debt limit hits the ceiling, risking a default on the government’s outstanding debt. We have more on what a default would mean below.
The last time the ceiling was raised was in December of 2021. It was put up by $2,500 billion. Now, the debt ceiling is in the news cycle again as the US risks going over again. To get Congress to agree, both Democrat and Republican lawmakers need to display bipartisan statesmanship by agreeing on terms to facilitate the increase. Naturally, this means it can be used as a political football.
In the absence of a workable budgeting policy from the government, some argue to get rid of the ceiling completely. After all, defenders of the ceiling risk a default. However, in the long term, those who defend the ceiling say that it enforces fiscal responsibility instead of blowing up a debt bubble that may burst, with disastrous consequences. Neither default nor burst is a good outcome.
What Happens If The US Defaults On Its Debt
The US has never properly defaulted on its national debt. So what happens? We don’t know for sure, only that it will be unprecedented and potentially chaotic. A very fast downturn is expected, with all of the bad omens that come with that like recession, redundancy, and even economic depression. With that, the already embattled US dollar gets weaker and may lose its position as world reserve currency, another catastrophic outcome. It also introduces a healthy dose of risk into those stable treasury bill assets we mentioned earlier, so nobody wants to buy government debt and interest rates spike.
Meanwhile, accruing endless debt while pushing the ceiling higher risks making the debt bubble pop in the longer term. When justifying new budgets that hack away at a government’s debt borrowing for services, there’s a risk that they’ll shave the bubble too closely and pop it. If you want to know what that would look like, you should re-read the above paragraph.