What is the Debt Ceiling and Why Does it Matter?

I am getting this question from quite a few people I talk to these days so I figured I’d just write a quick blurb on it.  What is the debt ceiling and why does it matter?

1)  The United States has run budget deficits for most of its existence.  This means the country spends more than it taxes and so it sells bonds to cover the difference.  This debt they sell contributes to the overall national debt.

2)  In 1917 the US government imposed a “debt ceiling”.  The debt ceiling is a restrictive limit on the amount of debt the US government can have in total.  So, if the US government adds $10 in debt in year 1 and then they implement a debt ceiling of $19 for year two then the national  debt can’t expand by more than $9 in year two without raising the debt ceiling.

3)  Going over the debt ceiling would mean the US government legally can’t pay its bills and would default on the national debt.  This would be catastrophic in ways that would make Lehman Bros look like a walk in the park.

4)  What’s strange about the debt ceiling is that it is not really a constraint on the size of the deficit.  That is, spending is appropriated BEFORE the fact and causes the debt levels to approach and perhaps breach the debt ceiling AFTER the fact.  I’ve compared the debt ceiling to eating a pizza and then tying your small intestine in a knot and threatening your stomach not to digest the pizza.  It seems like a rather silly way to go on a diet, right?  Anyhow, the government has untied the knot (raised the limit) 78 times since the debt ceiling was implemented.

5)  The USA is one of a handful of countries with such a limit.  Almost every other country in the world relies on the standard political debate process to agree on the proper size of government spending and taxation.

6)  The merit of the debt ceiling is hotly debated.  Is it a useful way to try to control government spending and spark debate?  I guess there’s some merit to that position, but I personally wish there was a more intelligent and thoughtful way to go about having these discussions without playing Russian Roulette with the credit of the US government once every few years.  Holding ourselves hostage under this self imposed rule shouldn’t be a necessary part of the political process and it’s a rather dangerous way to get things done.  After all, if we have to default on ourselves in order to cut spending then something much bigger is broken than the levels of government spending….

-------------------------------------------------------------------------------------------------------------------

Got a comment or question about this post? Feel free to use the Ask Cullen section or leave a comment in the forum.
Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

More Posts - Website

Follow Me:
TwitterLinkedIn

Comments

  1. A bit off-topic, but related to govt debt:
    George Gilder, on economics as a information system (sounds very “Austrian” to me, so I agree :-) ):

    Summing up the new economics of information are ten key insights:
    1) The economy is not chiefly an incentive system. It is an information system.
    2) Information is the opposite of order or equilibrium. Capitalist economies are not equilibrium systems but dynamic domains of entrepreneurial experiment yielding practical and falsifiable knowledge.
    3) Material is conserved, as physics declares. Only knowledge accumulates. All economic wealth and progress is based on the expansion of knowledge.
    4) Knowledge is centrifugal, dispersed in people’s heads. Economic advance depends on a similar dispersal of the power of capital, overcoming the centripetal forces of government.
    5) Creativity, the source of new knowledge, always comes as a surprise to us. If it didn’t, socialism would work. Mimicking physics, economists seek determinism and thus erroneously banish surprise.
    6) Interference between the conduit and the contents of a communications system is called noise. Noise makes it impossible to differentiate the signal from the channel and thus reduces the transmission of information and the growth of knowledge.
    7) To bear high entropy (surprising) creations takes a low entropy carrier (no surprises) whether the electromagnetic spectrum, guaranteed by the speed of light, or property rights and the rule of law enforced by constitutional government.
    8) Money should be a low entropy carrier for creative ventures. A volatile market of gyrating currencies and grasping governments shrinks the horizons of the economy and reduces it to high frequency trading and arbitrage in a hypertrophy of finance.
    9) Wall Street wants volatility for rapid trading, with the downsides protected by government. Main Street and Silicon Valley want monetary stability so they can make long term commitments with the upsides protected by law.
    10) GDP growth is fraudulent when it is mostly government spending valued retrospectively at cost and thus shielded from the knowledgeable judgments of consumers oriented toward the future. Whether fueled by debt or seized by taxation, government spending in economic “stimulus” packages necessarily substitutes state power for knowledge and thus destroys information and slows economic growth.
    11) Analogous to average temperature in thermodynamics, the real interest rate represents the average returns expected across an economy. Analogous to entropy, profit or loss represent the surprising or unexpected outcomes. Manipulated interest rates obfuscate the signals of real entrepreneurial opportunity and drive the economy toward meaningless trading and arbitrage.
    12) Knowledge is the aim of enterprise and the source of wealth. It transcends the motivations of its own pursuit. Separate the knowledge from the power to apply it and the economy fails.
    The information theory of capitalism answers many questions that afflict established economics. No business guaranteed by the government is capitalist. Guarantees destroy knowledge and wealth by eliminating the precondition of falsifiability. Unless entrepreneurial ideas can fail or businesses go bankrupt, they cannot succeed in creating new knowledge and wealth. Epitomized by heavily subsidized and guaranteed leviathans, such as Goldman Sachs, Archer Daniels Midland, Harvard and Fanny Mae, the crisis of economics today is crony statism.
    The message of a knowledge economy is optimistic. As Jude Wanniski wrote, “Growth comes not from dollars in people’s pockets but from ideas in their heads.” Capitalism is a noosphere, a domain of mind. A capitalist economy can be transformed as rapidly as human minds and knowledge can change.

  2. The last statement sums the whole situation. But what is that something big?
    No sane person eats a pizza knowing their intestine is knotted. They would not eat the pizza.
    With the modern ability to have instantaneous data like Walmart and its inventory and sales data,should not a so called developed economy like the USA have an annual budget and then look with pride at how well that budget tracked actual flows.
    It matters not whether there is agreement on a balanced budget or a certain deficit or surplus, just get a budget that the accountants can be proud to provide the citizens and the auditors can say was well developed.That this can not get done speaks loudly that the damn system is SNAFU.

  3. A structural theme of, Mr Roche…Debt, in the main, will ALWAYS be manageable as there will be a way out – Federal style..

    A balance budget nor a surplus is not material, after all debt can be always rationalized…

    3) ” Going over the debt ceiling would mean the US government legally can’t pay its bills and would default on the national debt. ”

    How can this be? Does not the Central government have a cash flow of some 2 trillion plus dollars?

    This crisis in the debt ceiling is nothing but a canard…

    Why are Treasury notes and bonds not selling off?

    I hope I am wrong, but one day you will see welfare programs and debt interest payment exceeding 50% of the entire budget in WDC…If so, will debt matter then?

  4. Is it possible that a technical default will rally stocks and bonds over the short run and push yields lower over the long run as the negative primary cash flow trend as well as the supply of treasuries would begin to stabilize offsetting any downward trends in international treasury purchases?

  5. Hans is correct. The government takes in 6 to 7 times the amount of money required to service its debt.

    If the debt is not serviced, it is because the administration has made a conscious decision not to service it. Not congress.

    The administration should most definitely be impeached if they choose this path.

    They might consider having Michelle not take some of her multi million dollar vacations, instead, among many other things that are far less important.

  6. Bingo! Obama pays the debt, but which payments get stopped? Who wins mid-terms?

  7. “Hans is correct. The government takes in 6 to 7 times the amount of money required to service its debt.”

    The catch is, any obligation that the govt has to pay (bondholders,federal worker wages, entitlement benefits, contractor payouts) is based on the credit of the United States. What’s more, investors employees, beneficiaries and vendors would all have a 5th Amendment property interests (creating procedural due process and in some cases substantive due process legal claims).

    The fact the Dept of Justice hasn’t been setting the table for this angle of attack suggests the govt has plans to do something else (the options are, cave or… do something awesome). :o)

  8. Nobody is against contract law I guess. Laws against murder & co are also welcome. Etc.

  9. “This means the country spends more than it taxes and so it sells bonds to cover the difference.”

    Doesn’t this mean the government balances its budget? Why balance if balancing a checkbook has no meaning for the government in this system?
    I thought bonds were just a no-risk investment, and they don’t fund anything.
    I thought taxes don’t fund anything either.

    I think the language is misleading. Isn’t the basic process that the government spends money into the private sector and then, to control the amount of money in the private sector, collects the money through taxes and bond sells?

  10. I think you’re using the MMT framework there. It’s better to think of the monetary system as being bank centric and not govt centric. The banks create the money and the govt just redistributes bank money through its taxation and spending.

  11. This is not a solution to the political malarkey we’re currently in, I think its a step in a logical direction-

    If a requisite to passing a budget was pre-approving funding via debt if necessary for that budget, we just have one concise debate about the matter and no possibility of default-by-impasse.

  12. That’s exactly why the Tea Party is doomed. The coupons will get paid, but SS checks will be delayed or maybe they’ll get some form of script, or nothing. It will only have to happen one time. Goodbye Tea Party, and write when you get honest work.

  13. That’s funny because Germany has this kind of bullshit legislation in the constitution.

  14. Hey Hans what’s up? Are you not Austrian? At least your name sounds so :-)

    Luckily I did not write it, just got it via John Mauldin so your wrath needs not fall on me, but on them.

    Anyway thank you for your insightful comments :-)

  15. Please allow to backtrack, Mr Roche…

    I used the post to save me another 7.9% on a new used vehicle…

    I think the saleswomen wanted me out of the office…

    I do applaud those that seek the abstract as a viable means of employment…

  16. Dear Mr X, I did not mean to be mean to you (besmirch) sir..

    Please except my apologize..I should have replaced cr$p with gobbledygook, but I do not know how to spell it and it maybe now political incorrect…

    Yes, I am a Vienna, but if this is what is means to be an Austrian, I am leaving the country…

  17. I’m continuing on my quest to understand: Where does money come from? Since our US fiat currency is not backed by Gold, Land, or actually anything but our “promise to pay”… this debt ceiling debacle is important and no joking matter–right? The world is awash with greenbacks, 60% or more of the world’s fiat currency is made up of USA debt dollars. It’s mostly held in the form of bonds and notes. Let’s say we’re are some lowly African country, something like Argentina or Zimbabwe, and the banks bailed on our notes and bonds simply because for 5 or 6 months or so we didn’t pay the interest …then what? Isn’t it true that just about the only actual thing holding our currency’s value is paying the interest on our bonds and notes. Diluting our currency a bit by deficit spending is nothing compared to ruining our currency by not doing the only thing that makes it of value in the world…our promise to pay.