Revenue & Spending
The Debt Ceiling: Why You Should Care and How It Came to Be
by Jessica Schieder, 10/8/2013
A self-inflicted economic disaster looms on the horizon. Failure to approve a routine measure allowing the U.S. to manage its finances and pay the bills it already owes would have devastating effects. Increasing the debt ceiling is the only way to avoid a destabilization of the American economy.
A Treasury Department report released Thursday clearly states, "Even the prospect of a default can be disruptive to financial markets and American businesses and families." The U.S. Treasury has been using extraordinary measures over the last several months to manage the country's bills – these measures will be exhausted on Oct. 17. That is the deadline for increasing the debt ceiling.
"The report states that a default would be unprecedented and has the potential to be catastrophic: credit markets could freeze, the value of the dollar could plummet, and U.S. interest rates could skyrocket, potentially resulting in a financial crisis and recession that could echo the events of 2008 or worse," according to the Treasury Department. "The report also notes that if the current government shutdown is protracted, it could make the U.S. economy even more susceptible to the adverse effects from a debt ceiling impasse than it was prior to the shutdown."
Understanding the seriousness of a possible default, House Speaker John Boehner's spokesman stated clearly late last week, "Speaker Boehner has always said that the United States will not default on its debt." But Boehner's aide attached a proviso: "If we're going to raise the debt limit, we need to deal with the drivers of our debt and deficits." However, in television appearances on Sunday, the Speaker seemed to back away from these assurances and said if the president failed to negotiate with the House, the president would be responsible for a default.
Business organizations like the U.S. Chamber of Commerce and the AFL-CIO have both demanded that the debt ceiling debate be removed from political posturing. President Obama and Senate Democrats have been demanding a "clean" continuing resolution (on the federal budget) and a "clean" debt ceiling bill. Yet a number of House members seem to be willing to "play chicken" with default, despite the serious economic repercussions it would have.
The Politics of the Debt Ceiling Crisis
The buildup to the debt ceiling deadline is taking place with the government shutdown as a backdrop. The government shutdown, which was triggered by the failure to approve a budget, and a potential default on federal debt are distinct crises, but both are being handled simultaneously by largely the same group of politicians. So while the crises involve different mechanisms, the politics and personalities handling the government shutdown overlap.
The national government partially shut down last week after Congress failed to approve a short-term spending bill. This failure occurred because of conservative intransigence against any bill keeping the government funded that included full support of the Affordable Care Act. Congressional Democrats and the president have rejected any spending bill that fails to fund the entire government, including the Affordable Care Act.
The president has asserted that he is willing to compromise on larger long-term budget matters but will not allow the debt ceiling to be used to extract concessions. One faction of one political party in one house of the legislature is betting on impossible concessions – essentially "hold[ing] the entire economy hostage over ideological demands," in the words of President Obama.
A default on American debt would be unprecedented. American prosperity depends in large part on low costs of borrowing and the risk-free nature of Treasury debt, both of which could be jeopardized by a default.
How the Debt Ceiling Came About
It is widely understood that Congress has the constitutional "power of the purse" – the ability to tax, spend, and authorize borrowing. Before World War I, the budgets produced by Congress contained specific financing instructions. Congress dictated the amount to be spent on projects (which it still continues to do), as well as how the Treasury would pay for such projects (i.e. interest rates, maturities, and details of when bonds could be redeemed).
Over the course of 19th century, Congress began to allow the Treasury more freedom to determine how bills would be paid. For example, by 1898, Congress gave broad guidance for funding for the Spanish-American War: it was to be paid for using "$100 million outstanding in certificates of indebtedness with maturities under a year … [and] $400 million in longer-term notes and bonds." Within these limits, there was "substantial administrative leeway" given to the Treasury, according to the Congressional Research Service (CRS).
Detailed financing instructions were gradually eliminated before World War II. Congress began to focus more on the quality and quantity of government investment, instead of the number and type of bonds being used to finance the spending.
Under President Franklin Roosevelt, Treasury Secretary Henry Morgenthau formally proposed in 1935 that Congress limit the total amount of bonds (debt) instead of limiting the sale of additional bonds (debt). Congress approved the first aggregate debt limit of $45 billion in 1939, which included all forms of American debt under one standardized limit. But when the U.S. entered WWII, the debt ceiling was quickly raised to over $300 billion, and debt after WWII rose to about 110 percent of Gross Domestic Product. (It fell quickly as the economy grew in the 1950s.) It was during the period since WWII that the modern consolidated federal budget came into being.
The debt ceiling has been raised 94 times since 1940, by both Republicans and Democrats. During the Reagan Administration, Congress raised the debt ceiling 18 times, more than any other presidency. A complete list of historical debt ceiling increases can be found here.
A Uniquely American Practice
No other modern nation handles debt like the United States. Denmark is the only other democratic nation with a debt ceiling (although Japan has a similar mechanism). Since its origin in the 1990s – due to reforms – Denmark has not yet used its debt ceiling as a bargaining chip in political negotiations.
Instead, the Danish debt ceiling is generously placed above actual debt, and the nation has avoided debt ceiling crises. Denmark has raised the limit only once in its history, and, even at that point in time, national debts totaled less than three-quarters of the limit. The chart below demonstrates the apolitical nature of the Danish debt ceiling.
From an economic perspective, the continued existence of a debt ceiling that could initiate a default is a massive risk in itself. A 2011 Financial Times editorial commented on the harmful instability caused by the debt ceiling, saying, "Sane governments do not cast doubt on the pledge to honor their debts – which is why, if reason prevailed, the debt ceiling would simply be scrapped."
The Center on Budget and Policy Priorities (CBPP) has commented, "It makes little sense to have a limit on federal debt that is divorced from the budgetary decisions that largely determine the amount of debt incurred."
From time to time, there have been calls to abolish the debt ceiling or reform the way it is increased (by vesting it in a body aside from Congress), because it has been used to extract concessions that otherwise would have been unpalatable. The latest laundry list of Republican demands is an example of this.
What Are We Risking?
As the nation nears possible default, the full faith and credit of the United States is at risk. Besides destabilizing the American recovery from the Great Recession, instability in the American market will ripple around the globe.
Consumer confidence is expected to fall and financial markets would be chaotic in the face of an actual default. The cost of borrowing would increase dramatically, potentially catalyzing a credit freeze.
The mere threat of default in 2011 cost the country $19 billion through increased interest rates in the Treasury market, according to an estimate by the Bipartisan Policy Center.
As the largest economy in the world, the United States produces almost 22 percent of the world's annual gross domestic product (GDP), according to the World Bank. A politically induced economic crisis caused by a debt default could damage the American "brand" abroad, driving foreign investment out of the United States.
Triggering an Economic Crisis through a Default
Unless the debt ceiling is increased, the government will default on obligations on Oct. 17.
To prevent such a crisis, a wide range of diverse American constituencies, from the Chamber of Commerce to the AFL-CIO, have called for a debt ceiling increase.
But the frustration produced by this latest debt ceiling debacle has left many experts looking for an escape hatch in the event Congress does not act in time.
Legal experts have drawn attention to proposals which might at the last minute avoid a default. Some have proposed that the president could invoke the 14th amendment and continue borrowing to pay debts. The 14th amendment includes a provision that states that the U.S. must pay its debts – and thus cannot default. The specific phrase in question is worded as follows:
The validity of the public debt of the United States, authorized by law, including debts incurred for payments of pensions and bounties for services in suppressing insurrection or rebellion," the critical sentence says, "shall not be questioned.
The provision was originally intended to "ensure the payment of Union debts after the Civil War and to disavow Confederate ones," according to The New York Times' Adam Liptak. Former President Clinton endorsed using the 14th amendment during the 2011 debt ceiling crisis as a means to avert an economic disaster. However, the Obama administration remains unconvinced that using the obscure provision would be a valid option. President Obama has clearly stated his legal advisors "are not persuaded that that is a winning argument." Many others have cast doubt on this option as well.
If invoking the 14th amendment is not an option, other experts have suggested the Treasury could "prioritize" certain payments to avoid defaulting on an interest payment. Under such a scenario, the United States would likely prioritize paying interest payments over obligations to the American people. Promised Social Security checks, Medicare reimbursements, and other entitlement programs would then be paid with what money is left, but it is unlikely guaranteed benefits could be dispersed in full or at expected intervals.
These suggestions would be last-ditch efforts to prevent a crisis that no one wants and the American economy does not need as it recovers from the Great Recession. Raising the debt ceiling is in the interest of every American, so Congress should do it as soon as possible to promote the interests of the American people. In addition, long-term reforms should be made to avoid these types of crises from taking place in the future.