Does the debt ceiling actually do anything?

Since its establishment in 1917, the US debt ceiling (basically the government’s credit limit) has been increased by Congress 90 times. You read that right – ninety times. You likely remember many past instances of Congress squabbling over whether to raise it, and you are likely aware that another such squabble is underway right now.

This phenomenon regularly leaves Americans feeling baffled and a little (or a lot) angry. You and I cannot just raise our own credit limit at will, so why does the government get to do so? Does this mean they can just keep borrowing forever without any consequences? And most importantly – what if they don’t raise the debt ceiling? Does it really matter in the first place?

How the debt ceiling works

As mentioned above, one easy way to think of the debt ceiling is to compare it to the spending limit on your credit card: a set dollar amount of debt that cannot be exceeded. But the obvious difference is that your borrowing limit is enforced by the credit card company, while the government has no single lender calling the shots.

The government’s debt is spread among millions of creditors – mostly bondholders. Although demand for bonds will ebb and flow, there will always be people willing to buy them so long as they are confident of getting timely interest payments in return. In other words, the government will always have lenders available who do not give a rip about the federal deficit.

So yes: the government ends up having to hold itself accountable. One arm of it (the Treasury) actually does the spending, while a separate arm (Congress) approves that spending. The debt ceiling just streamlines this process: it “pre-approves” the Treasury for a certain amount of debt so it can borrow money without bugging Congress for permission every single time.  

Unfortunately, while you and I do not need to regularly max out our credit cards to get by (at least I hope not), the Treasury is not so lucky. Bills always need to be paid, and they always exceed tax revenue, so the Treasury is constantly borrowing more to make up the difference. This makes it inevitable that they will hit the debt ceiling sooner or later.

Why the debt ceiling keeps getting raised

The upshot of all this is that Congress does not raise the debt ceiling to make room for future spending, but rather to accommodate spending that has already happened. Once the debt ceiling is hit, the Treasury can no longer keep borrowing and instead must rely solely on cash reserves until a new debt limit is approved. Congress raises the ceiling to get them out of that tight spot.   

The good news is that once the debt ceiling is hit (as it was last month), it is not the end of the world just yet. The Treasury has all kinds of budgeting tricks it can use to stretch out its cash while waiting on a lifeline from Congress. The bad news is these tricks will not work indefinitely, and often amount to some degree of government shutdown – suspending services, withholding paychecks, etc.

The very bad news is that, if Congress does not approve a higher debt limit before that cash runs out, there is real risk of government default. Remember, the government owes money to millionsof creditors, so it always has loans coming due. If the Treasury runs out of cash and is alsounable to borrow more, guess what? Loan payments get missed, otherwise known as default.

It is hard to say exactly what would happen if the US defaulted on its loans, but we can safely assume it would be bad. Effects could include market shocks, spiking interest rates, widespread job loss and, of course, recession. With stakes like that, the next question is obvious: why on earth wouldn’t Congress raise the debt ceiling right away?

How the debt ceiling could break

Although Congress can at least agree on the importance of avoiding government default, that does not stop them from trying to use it as a bargaining chip. Once the debt ceiling is hit and the clock starts ticking, legislators often use that pressure as an opportunity to extract promises from one another and the President.

In short, it becomes a game of chicken, with different sides telling each other “I will not vote to raise the ceiling until XYZ is cut from the budget!!”

To be fair, Congress has managed to salvage this situation each time previously. As fund manager and finance professor Patrick Boyle explains it, “legislators negotiate, make threats, and then at the last minute get their act together and agree.”

Still, there is always the worry that thistime will be different. Congress seems to have been getting more and more polarized, and perhaps one of these days they will let their game of chicken go on too long. What then?

What if the debt ceiling breaks?

First, a quick synthesis of what we have learned so far:

  1. Contrary to what many people suspect, the debt ceiling is not just a charade that Congress waves away whenever they want to start another war or subsidize electric cars.
  2. Of course, it clearly does not function as a real barrier to spending either.
  3. It may be better to think of the debt ceiling as a speedbump:
    1. It forces the Treasury to slow down current spending;
    1. It forces Congress to look at how future spending can be cut.
  4. A big problem with the debt ceiling is that it periodically puts the US at risk of credit default.

As noted above, government default would have truly ugly effects. But is raising the debt ceiling – and therefore the national debt itself – really any better? Many of the effects that we fear from a default are also plausible from an ever-growing loan balance. They may not happen as immediately and clearly, but the risk is still very real.

At the end of the day, the same thing is true of countries as of individual households: you cannot borrow your way out of debt. You have to save, which means cutting costs, which means adjusting your lifestyle, which is a hard thing to do. So hard, in fact, that sometimes natural consequences end up doing it for you.

Breaking the debt ceiling may bring about those sorts of consequences. It is a scary prospect – one I personally am not looking forward to (nor necessarily expecting). But in the long run, I do not think it would be the end of the world or even the US. Who knows, it may even force our economy into a new, more sustainable direction.  

In any case, I do not think the federal deficit is reason for individual investors to panic. I have said it before and I will say it again: the global economy is bigger than the US, and you have the tools to invest in it. That is reason for optimism.