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

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