The US Debt Ceiling Explained

The financial markets have built us a system wherein society, including governments thrive on debt. The simple premise being that the more you borrow to spend, the brighter the chances for an improving economy. Old-school thinking on the contrary is of the opinion that economic growth does not necessarily have to be based on debt and borrowing, but that’s a different story. It is no wonder then, that money printing, or Quantitative Easing has become the primary tool for Central banks across the world to boost the economy. Ever heard of the phrase ‘Do not live beyond your means?’ Well that doesn’t apply at a government level. Just so you know, the current US Debt Ceiling is at $US16.7 trillion which the Treasury Department alerted that it could be hit by mid-October 2013.

US Treasury Secretary Jacob Lew
US Treasury Secretary Jacob Lew

The Debt-GDP Ratio

A better know statistic used to measure the debt is known as the GDP-Debt Ratio which is the size of the country’s debt to its borrowings and is used as a yardstick to measure a country’s financial health. A Debt-GDP ratio of up to 50% is considered to be a healthy reading while anything above 90% marks the danger zone. As of 2012, the US Debt-GDP ratio stood at 102.9 while the estimates for 2013 stand at 105.6.

What’s important to note here is two countries for example can have a higher Debt-GDP ratio yet they may not fall into the same category. A good example to illustrate this is the debt-GDP ratio of Japan and Greece.

In 2012, when Greece markets collapse, its debt-GDP ratio stood at 157%, while at the same time, Japan’s debt-GDP ratio was at a staggering 233%. The answer as to why so much of discrepancy is based on various other factors such as the country’s economic growth, budget controls and so on… (not to forget the country’s ability to print more money)

The US Debt Ceiling Explained

So what exactly is the US Debt Ceiling and how does it work?

The Debt Ceiling is the total amount of money that the (US) Government is authorized to borrow in order to meet its existing financial obligations such as sending out social security checks, military spending and so on, with the key focus being on ‘existing financial obligations.’

The finances of the government is handled by the Treasury Department and it is they who usually alert the government of the money flows. So when spending increases while incoming revenue drops, the debt ceiling is reached quite quickly. It is the duty of the Treasury Department to alert its government beforehand so that Congress and the Senate can agree on the best course of action (which has to date been increasing the debt ceiling, but not without putting up a show at the highest levels of the government).

It is a sad truth that the taxes and other means for raising revenue seldom fail to meet the governments spending, which is why the ‘Debt Ceiling’ was introduced in the first place.

The ‘debate’ on Debt Ceiling, interestingly has come up 78 times since 1960.

In a letter date 17/5/13, Treasury Secretary Jacob Lew mentions in this letter to House Speaker John Boehner:

“It is important to note that increasing the debt limit does not increase spending or authorize new spending; rather, it simply permits the United States to continue to honor pre-existing commitments to our citizens, businesses, and investors here and around the world. These commitments were already approved by congress, and honoring them is not optional.”

In other words, the US Government must continue borrowing in order to meet its existing financial obligations, as against borrowing to fund new projects.

How does the US fund its debt

When we talk about debt, there are basically two kinds that we are dealing with. Debt is categorized into the following two:

  • Public Debt: Debt held by the public via securities and bonds sold to investors (including international investors such as China, Japan, Russia and so on)
  • Government Account Debt: This is the debt which is held by government accounts via trust funds such as Social security, Medicare, Disability account and so on.

As of the end of the 2011 Fiscal year, Public debt stood at $10.1 trillion while Government accounts debt stood at $4.7 trillion. Debt can also be purchased by foreign governments. Below is a table of the Top 10 Foreign holdings of US debt.

Top 10 US Foreign Debt Holders
Top 10 US Foreign Debt Holders (Source)

In order to borrow, the government issues securities to the public/markets also known as the Bond Markets which is estimated to be much bigger than the equity markets. These can be traded directly thus ensuring liquidity. Public can either buy the securities directly from the TreasuryDirect website or can buy them off from other investors as well. The biggest purchaser of US Bonds is the Federal Reserve (as part of its quantitative easing policy, currently purchasing close to $40bn in treasuries every month) followed by foreign government holdings, with China being the biggest purchaser of US Debt. Bonds are backed by the trust and full faith of the US Government to pay up its obligations, which is why they are the most sought after investment vehicles (and thus interest rates are quite low in comparison).

What happens if Congress fails to increase the debt limit

If congress fails to increase the debt ceiling, the government would be stuck in a corner without having any money to meet all of its obligations such as Social Security, Medicare, tax refunds and so on, causing a lot of hardship and as well make international investors take notice of a potential default on payments by the US Government. So does this mean the Government will shutdown? Not entirely. In the event Congress fails to raise the debt ceiling, the US Treasury would have to prioritize its payments, meaning that less influential projects will be temporary put on hold while the more immediate obligations get precedence.

Given that the US Government is the largest issuer of Government backed bonds, it is considered to be one of the safest investments available today. Thus a hint of doubt in this regard would send bond yields spiralling upwards, making it more expensive for the US Government to borrow.

Last year in August (2012) as the US Congress failed to reach an agreement on the US Debt Ceiling, ratings agency, Standard & Poors downgraded the US investment rating from AAA to A+ (the fact that this downgrade didn’t really drive a dent to the US, is a different story and one that is perfectly explained here.)

About the author: Editorial Team

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