Congress created the debt ceiling in the Second Liberty Bond Act of 1917. It allowed the Treasury Department to issue Liberty Bonds so the U.S. could enter World War I. It also gave Congress the ability to control government spending.
The debt ceiling forces a conversation between the President and Congress to become more accountable in fiscal policy. Without it, the annual U.S. budget deficit pushes the national debt higher and higher. That's because there is very little incentive for politicians to curb government spending. They get re-elected for creating programs that benefit their constituency and their contributors. They also stay in office if they cut taxes. Deficit spending does, in general, create economic growth. There's only a concern if the debt to GDP ratio gets too high -- above 90%. Then debt owners become concerned that a country can't generate enough revenue to pay the debt back.
For this reason, the conversation about the debt ceiling is usually brief. Congress and the President simply agree to raise the debt ceiling. In the last ten years, Congress has increased the debt ceiling ten times -- four times in 2008 and 2009 alone. If you look at the debt ceiling history, you'll see that Congress usually thinks nothing of raising the debt ceiling.
Why the Debt Ceiling Matters
However, Congress delayed raising the debt limit in 1985, 1995-1996, 2002, and 2003. It threatened to do so again in 2011.Congress did raise the debt ceiling in early August by passing the Budget Control Act.. This required a Congressional Committee to suggest ways to reduce spending. The Act allows the debt ceiling to be raised to $16.694 trillion, assuming Congress approves the spending plans. This uncertainty was one reason the bond rating agency Standard and Poor lowered the U.S. credit from AAA to AA. This caused the stock market to plummet.As the debt approaches the ceiling, Treasury can stop issuing Treasury notes, and borrow from some retirement funds (but not Social Security or Medicare). Normally, it can withdraw around $800 billion it keeps at the Federal Reserve bank. Between 2008-2010, the Fed vastly increased the amount of Treasury notes it held, a policy known as Quantitative Easing. Congressman Ron Paul (R-Texas), Chair of the Fed Oversight Committee, has suggested that the Fed could forgive the $1.6 trillion in debt it owns. This would postpone the need to raise the debt ceiling.
What Happens If the Debt Ceiling Isn't Raised?
Once the debt ceiling is reached, Treasury cannot auction new Treasury notes. It must rely on incoming revenue to pay ongoing Federal government expenses. This happened in 1996, and Treasury announced it could not send out Social Security checks.Competing Federal regulations make it unclear how Treasury could decide which bills to pay, and which to delay. Owners of the debt would get concerned that they may not get paid.
If Treasury did actually default on its interest payments, three things would happen. First, the federal government could no longer pay any its employees' salaries or benefits. All those receiving Social Security, Medicare, and Medicaid payments would go without. Federal buildings, and services, would close. Second, the yields of Treasury notes sold on the secondary market would rise. This would create higher interest rates, increasing the cost of doing business and buying a home. This would slow economic growth. Third, foreigners would dump their holdings. This would cause the dollar to plummet, probably removing its status as the world's reserve currency. The standard of living in America would decline. This would make it highly unlikely that the U.S. could ever repay its debt. For all these reasons, Congress shouldn't monkey around with raising the debt ceiling. If members are concerned with government spending, they should get serious about adopting a more conservative fiscal policy long before the debt ceiling needs to be raised. (Article updated August 16, 2011)
