Debt Ceiling – what most get wrong
The Debt Ceiling is a cap set by Congress on the amount of debt the federal government can legally borrow. The cap applies to debt owed to the public, (meaning anyone who buys U.S. bonds) plus debt owed to federal government trust funds such as those for Social Security and Medicare. The limit was first set in 1917 at $11.5 billion. Previously, Congress had to sign off every time the federal government issued debt.
The ceiling is currently set at $14.294 trillion. The debt blew past that mark on the morning of May 16. By taking various measures like suspending investments in federal retirement funds, Treasury Secretary Tim Geithner has been able to bring total debt down enough to allow the government to continue borrowing until Aug. 2.
If the debt ceiling is not raised, it is unlikely that the Federal government would default on bond or Social Security payments, but rather implement some other combination of spending cuts and/or tax increases.
Currently the federal government spends $1.4 trillion more than it receives in tax revenue. Without an increase in the debt ceiling, the federal government would have to cut this much in spending which would mean that approximately 9.3% of GDP ($1.4 trillion / current GDP of about $15 trillion) would be withdrawn from the Federal government’s spending in the economy.
You’ve may have seen economists and politicians go into apoplectic fits over how this means an immediate 9.3% reduction in GDP, which would clearly be disastrous for the economy. This is another example of Keynesian math gone wrong as the money that would have been borrowed by the government to fund this excess spending would not just disappear into thin air. Does it really make sense that we have two options, the government borrows and then spends $1.4 trillion OR that $1.4 trillion ceases to exist? Those funds would still exist and likely be invested or spent elsewhere – potentially generating even more than $1.4 trillion in the economy.
That being said, given the magnitude of cuts that would be required, we believe it is unlikely that Congress will not raise the limit at some point, however it could possibly do so after the August 2nd deadline. In fact, the markets would likely prefer a delay in raising the limit that is accompanied by a credible plan to reduce the deficit and the national debt, versus an increase that is not accompanied by any credible plan. Think of it this way, you lent money to your neighbor a few years back and now see that he is simply digging himself deeper into debt. Would you rather have him continue getting new credit cards just to pay you the interest on your loan or would you prefer to have him miss a payment or two while he develops a reasonable way to cut his spending so that you are confident that not only will you get your interest payments, but also your principal?
Bottom Line: Be wary of the overly simplistic math used in most of the media these days. The slogan, “If it bleeds it leads,” is alive and well and financial Apocalypse headlines make for sensational copy and help politicians garner valuable air time.
