The Roof is On Fire: The Dangers of Reaching (and Raising) the Debt Ceiling

When is raising the roof a bad thing? When we’re talking about the debt ceiling. As an avid talk radio fan, I have been hearing about the debt ceiling for several months now. As we get closer to the August cutoff date for preventing a total financial meltdown, it is important to understand why the stakes are so high and why there are no easy answers to this problem.

What is the Debt Ceiling?

Put simply, the debt ceiling is the legal limit placed on the amount of money the United States can borrow. It is similar to the spending limit put on an individual’s credit card. When the limit is reached, no more credit is extended. The United States reached its credit limit of $14.294 trillion on May 16, 2011. So, the United States should just stop borrowing money, right? Well, that would be great–except that our nation spends roughly $120 billion more than we take in through revenues each month. Yes, really. Where have we gotten that money? We have borrowed it. But now, our credit line has run out.

To avoid a meltdown, the Treasury has resorted to extraordinary measures. Our government has an account at the Federal Reserve containing roughly $100 billion dollars. We are going to tap into that. However, if you’ve done the math, you realize that does not cover even one month of expenses.   Up until this point, we have regularly borrowed from local governments, and from pension plans that serve federal employees. We are going to stop doing this and only borrow for essential needs which gives a bit of wiggle room. Even with extreme measures, August 2nd looms as the date when the government will cease to be able to make payments on its debt.

How Did We Get Here?

Since the end of World War II, Congress has acted 78 times to raise or revise the U.S. debt ceiling–the amount of money our government may borrow to repay bond holders. This is not a single-party issue: those 78 raises occurred 29 times under Democratic administrations and 49 times under Republican leaders. Most recently, the debt limit has been increased under Reagan, Bush, and Clinton. The last year we had a surplus was 2001; from then until 2009, spending increased by 6.5% of the GDP and tax revenues decreased by 4.7% of the GDP. In essence, our government taxed less and spent more.

So, if it’s happened before, what’s so special about it this time? The problem we face now is that this debt has grown exponentially, much like a snowball going down a hill. Our current debt is nearly equal to our entire U.S. economy of $15 trillion. As the debt grows exponentially, so does the interest–making it harder and harder to catch up.

So, What Are Our Options?

There are a few potential outcomes. One is that we run out of credit and default on our loans. To call that scenario catastrophic would be an understatement at best. Another possibility is that the government finds a way to keep paying the interest on our debts, but stops all payments on the principal.   If we pay only the interest, our credibility falls drastically. The stock market would see a marked increase in sell-offs, the SEC would cease trading activity, and world financial markets would freeze. Basically, the dollar would be in free-fall. What would this mean for you and for me? We would most likely be unable to access our bank accounts (think the ‘run on the bank’ scene from It’s A Wonderful Life), ATMs would stop working, and employers could have trouble paying employees because the credit market would be frozen. Scary stuff. But it could be worse…

If we actually defaulted–which most financial analysts refuse to consider because it is unimaginable–the repercussions are almost unfathomable. Foreign investors would stop investing in the dollar and turn to other currencies, damaging the dollar to such an extent that it could take years to recover. One of our loan holders, China, has already warned the US to get it together on the debt crisis; the advisor to China’s Central Bank recently stated that he fears default is likely and that the value of the dollar will diminish.

Whether we went to interest-only payments, or defaulted on our loans entirely, our reputation or credit rating, if you will, would plummet. Other countries would be hesitant to loan us any further money and any loans given would have much higher interest rates, just as it is for many individuals who have poor credit ratings.   This makes it sound like raising the ceiling is our only option, but that scenario has dire consequences as well. Raising the debt ceiling means owing more money; again, this debt-to-revenue imbalance hurts our credit rating with potential lenders which results in a deflated dollar and higher interest rates.

What Happens While We Figure This Out?

As I mentioned, our Treasury has been taking extreme measures to scrape together funds to cover the gap while our legislators decide which course of action to take. Treasury Secretary Tim Geithner has gone so far as to use federal employee payroll deductions to fund government obligations instead of paying into those employees’ retirement funds. This would be akin to your boss taking your 401(k) contributions and using them to pay for current company expenses instead.

Historically, the United States has had a reputation for reliably paying back its debts. This has earned us access to low interest rates. As previously mentioned, the closer we get to that August deadline, the more other countries lose faith in our financial stability. As markets fear that this debt issue will not be resolved anytime soon, our government will begin seeing interest rates rise. When the government has to pay more to borrow, this will get very expensive for taxpayers very quickly. Every incremental increase could mean hundreds of millions of dollars passed on to taxpayers. If by chance we should miss our August payment or the payment after that, our rating would immediately be downgraded by Moody’s and Standard & Poor’s. The prospect of the United States losing its AAA credit rating is staggering.

What is the Outlook?

At this point, our legislators are truly divided on how to address the looming debt deadline. Republican leaders are strongly opposed to raising the debt ceiling, for obvious reasons. They feel that doing so would be ‘kicking the can down the road’ and merely postponing the inevitable need to get a handle on our debt. They point to outrageous pork barrel spending and want to make sweeping, severe spending cuts in order to help get our federal budget back in order.

Democratic leaders are coming at the problem from a different angle. They feel that tax cuts have led to the budget crisis and would like to reinstate the individual and corporate taxes that were cut under prior presidential administrations.

With Republicans staunchly opposed to raising the debt ceiling without slashing spending–in fact, they are asking for any increase in the debt ceiling to be offset by an equal cut in spending–and Democrats insisting that any compromise must include tax increases, it is hard to see how the two sides will come together any time soon. This is most discouraging, because every day that we wait to act lowers our financial credibility in the eyes of the world. There is little doubt that those eyes will be focused sharply upon us as the August deadline grows nearer.