By Kristin Carew, Carnegie Mellon University
For the last several weeks, news coverage of the budget impasse in Washington, D.C. has been dominated by the threat of a government shutdown. A shutdown would have had serious consequences, including the unpaid furlough of 800,000 non-essential government employees, interruptions in pay for military personnel, delays in processing tax refunds, and the suspension of services ranging from trash collection to the operation of museums and national parks around the country. After a long, contentious debate, a deal in which Republican Speaker John Boehner negotiated $38 billion in spending cuts for the remainder of 2011 was reached with less than two hours to spare. However, an issue carrying even graver potential consequences is now in the spotlight: the debt ceiling. Unless Congress reaches a speedy agreement to raise the debt limit from its current level of $14.294 trillion, the United States is expected to reach this threshold by the middle of May.
The debt ceiling is a limit placed upon public debt, which includes Debt Held by the Public and Intragovernmental Holdings. Public debt refers to money that the government borrows, usually via securities like U.S. Treasury notes or bonds. Debt Held by the Public includes all federal debt securities held by institutions or individuals outside of the U.S. government; this category includes debt held by Americans and debt held abroad. Intragovernmental Holdings are U.S. Treasury securities held in accounts owned by the U.S. government, such as the Social Security Administration’s trust fund. A debt ceiling was first established by the Second Liberty Bond Act in 1917, and it allowed the U.S. Treasury to issue new debt without seeking the approval of the U.S. Congress for individual debt offerings. This act gave the Treasury the ability to operate with greater freedom and to manage government finances more effectively. Incremental changes to the debt limit occur frequently, often multiple times per year. This time, however, it has become a much more controversial matter. The most obvious reason is that, since early this year, the United States has had a divided Congress, in which a different party controls each house of Congress. Because cutting excess deficit spending and reducing national debt are major campaign issues for the Republican Party, Republican members of Congress have been extremely hesitant to make concessions to Democrats in Congress or to President Obama.
The direst potential outcome cited in favor of raising the debt ceiling is that freezing it could cause the U.S. government to default on its existing debt securities, because the Treasury covers payments on outstanding debt by issuing new debt. Breaching the debt ceiling would prevent the Treasury from rolling over debt in this manner. A default by the United States would have dire consequences for the global economy. U.S. Treasury securities are widely regarded as one of the world’s safest investments and thus are held by investors unwilling or unable to tolerate a default on payments. The financial crisis and the global recession that followed served to stimulate the world’s demand for riskless investments, so Treasury securities have become more popular and more widely held in recent years. Moreover, Treasury securities are commonly used as a benchmark for determining the risk-free interest rate, or the rate of return on investments that have no default risk.
A default by the United States government, like a default by any borrower, would raise the cost of its future borrowing. Because such a default would shatter the perception that Treasury debt is riskless and leave investors with the impression that the United States is not willing to honor its debt obligations, some of this increased borrowing cost could be permanent. Treasury Secretary Timothy Geithner, who has publicly lectured Congress on the risks of leaving the debt ceiling at its current level, warned that a default would also force payment cuts upon the military and senior citizens. U.S. Treasury securities are such a deeply ingrained part of the international financial system and of American government financing that their default, a nearly unprecedented event barring the official repudiation of debt obligations during the Great Depression, has the potential to cause another financial crisis.
However, debt ceilings exist for valid reasons, and there are legitimate grounds to question another increase. There is an ongoing debate among economists about whether excessive levels of debt can be dangerous for a country, and if there is such a level, what percentage of GDP would have to be exceeded in order to create a situation in which economic growth is suppressed. Economists Kenneth Rogoff and Carmen Reinhart, who testified before the U.S. Senate last year, found in their research that debt in excess of 90% of GDP represents such a level. United States debt is already in excess of 90% of GDP and was measured at approximately 97% of GDP at the end of March. However, other economists have disputed the causality of debt to low growth, arguing that nations already suffering periods of low growth increase their debt levels. The “dangerous level” threshold aside, carrying large amounts of debt is known to affect inflation, interest rates, and economic growth. In accordance with this, the Republican position in the debt ceiling argument has been that, in order to justify raising the debt ceiling, additional spending cuts must be implemented to ensure that debt levels do not continue to rise in an unsustainable manner.
Considering the consequences of refusing to raise the debt limit, it seems likely that an agreement to increase it will be made before the debt ceiling is reached. However, the question of the debt ceiling raises an important issue: what is the appropriate debt limit for the United States, and where should we draw the line on borrowing and turn instead to tax increases or spending cuts to keep up with debt repayment and other necessary expenditures? Given the current political divide in Washington, it seems very unlikely that this broader issue will be settled any time soon.
