Why the Debt Ceiling Is Important, and Its Impact on the Markets and Economy

Should the debt ceiling be eliminated? A bit of history and a little forecasting.

 

Congress on both sides of the aisle is playing a game of political chicken with the debt ceiling (see latest developments here); but what would actually hitting the ceiling mean for the markets and the economy in general?

Although the U.S. hit its $14.3 trillion debt ceiling on Monday, May 16, economic Armageddon hasn’t yet rained down on the U.S. economy. Thanks to some slick Treasury Department maneuvering, the date when the U.S. really reaches the limit has been pushed to around August 2.

But instead of breathing a sigh of relief and resolving to engage in a bipartisan effort to resolve the debt ceiling issue in advance of the August drop-dead date, both sides are likely to wait until the last moment to avoid impact—threatening our fragile economic recovery in the process.

What Happens if We Hit the Debt Ceiling?

According to Treasury Secretary Timothy Geithner, reaching the ceiling would force the government to default on some of its obligations, which would have a “catastrophic economic impact.” 

In the—however unlikely—worst case scenario, if the federal government is unable to borrow additional money, it could default on some of its obligations. Funds brought in from new debt issues are used to make principal and interest payments on the national debt. Without the ability to borrow additional funds, the Treasury could be forced to default on some of its debt.

Last week, the ratings service Moody’s warned that “if there is no progress on increasing the statutory debt limit in coming weeks, it expects to place the U.S. government's rating under review for possible downgrade, due to the very small but rising risk of a short-lived default.”

Despite assurances by some Republicans and othersthat default would have little concrete effect on government operations or the economy, the effect would likely be devastating. A U.S. default would ripple through the world economy and markets, destabilizing every corner of the markets. Trillions in capital would vanish from world markets in the blink of an eye.

“Without an increase in the debt limit, the Treasury would be unable to meet all of the government’s existing obligations, which could undermine the U.S. government’s reputation in capital markets and raise costs of federal borrowing,” according to the Congressional Research Service’s recent history on the debt limit. An increase in the cost of borrowing for the U.S. would then increase the cost of borrowing for corporations and other borrowers, stunting economic growth.

Is it Time to Eliminate the Debt Ceiling?

Some commentators have suggested eliminating the debt ceiling, arguing that other checks and

 

balances have replaced the need for the limit. The ceiling was first put into to place to prevent continuous financing battles in Congress that could hamper the Treasury’s ability to fund the government’s operations.

But the debt ceiling plays a valuable role in Washington by forcing periodic debate and compromise in Congress and forcing our elected officials to justify their unbalanced budgets.

Prior to World War I, Congress had to approve every debt issuance. The debt ceiling was introduced to give the Treasury the flexibility it needs to finance the federal government without being forced to seek Congressional approval at every turn.

As evidenced by the widespread coverage of Congress’s debt talks in the mainstream media, the debt ceiling still serves an important purpose by forcing our elected officials to publicly justify their spending.

So, Will We Hit the Ceiling?

The answer is “Probably not.” The debt ceiling has been raised about 80 times since it was enacted in the early 20th century. It’s hard to believe that Republicans are doing anything here other than playing political chicken with the debt ceiling. August 2 gives them enough time to make their pre-2012 elections point, get some spending cut concessions from the Democrats, and then sign on to an increase.

But all is not well that ends well. The longer Republicans wait to increase the debt ceiling, the greater the chance the country’s cost of borrowing will increase. Approaching the absolute drop-dead date of August 2 and then increasing the limit at the 11th hour increases uncertainty in the markets and will likely push up the government’s cost of borrowing.

Although the markets didn’t see a precipitous drop in the lead up to the soft May 16 deadline, you can bet that stress in the markets will increase exponentially the closer we get to August 2 without an agreement to extend or eliminate the ceiling.

 

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See also The Law Professor's blog at AdvisorFYI.

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