Everything You Need to Know About the Debt Ceiling

Congress made a deal to avoid the fiscal cliff, but you don't actually think we're done with 11th-hour partisan battles that bring the country's finances to brink of ruin, do you?

Of course we're not. Sometime in the next six weeks, the Treasury won't have enough money pay the government's bills. Prevented from borrowing more because of the self-imposed debt ceiling, we'll face two options: Either Congress must agree to raise the debt ceiling, or something awful will happen.

Confused? Here's what you need to know.


What is the debt ceiling?
Before 1917, Congress literally had to approve each new debt issuance, deciding on the bond's maturity, its interest rate, and what the money was specifically to be used for.  

This became too burdensome on the eve of World War I, when the government needed to quickly spend a lot of money without stumbling over administrative rules. So, in 1917 Congress passed the Second Liberty Bond Act, which provided authority to issue new debt with relaxed restrictions on the maturity and redemption of bonds being issued.

Those restrictions were eased throughout the 1920s and 1930s until being removed in 1939, replaced by an aggregate debt limit. After that, Congress basically told the Treasury: "You can borrow this much money. Go figure out the best way to do it." When the limit was hit, Congress raised it. Thus began the modern debt ceiling. 

What's happened since then?
Since 1939, Congress has raised the debt ceiling 83 times, or about every nine months. It's usually raised without any fanfare or protest. Raising it became an issue only in recent years, when parties realized it could be used as a bargaining chip.

Logically, there's no reason for there to be any protest. The most important thing to understand about the debt ceiling is that it doesn't control how much money Congress spends. It controls the ability to pay for what Congress has already agreed to spend.

What's happening now?
The current debt limit, $16.39 trillion, was hit last week. The Treasury can still pay the government's bills on time by juggling around payments -- what it calls "extraordinary measures" -- but only until the middle of February. After that, the government's previously agreed-upon spending will exceed tax revenue, and without the ability to borrow more, the Treasury won't have enough cash to pay its bills.

What happens then?
We've never not raised the debt ceiling, so there's no precedent for what might happen if Congress doesn't reach an agreement.

The Bipartisan Policy Center estimates the Treasury will receive $277 billion in tax revenue between Feb. 15 and March 15 and owe $451 billion in spending commitments, much of which are tax refunds. So just in the first month, there's $174 billion in bills that the Treasury would be unable to pay.

Legal scholars and government officials, including Treasury Secretary Tim Geithner, dispute the idea that the Treasury can "prioritize payments" to pay the most important bills first and may instead be forced to pay obligations on a first-come, first-serve basis.

Assuming the Treasury could prioritize payments, the BPC created a scenario of what the government could and could not pay for in the first month:

Mix these up any way you'd like. Someone or some program that most people would deem a "priority" isn't getting paid.

And that's important in the eyes of global financial markets. Even if bond interest is prioritized and paid on time, it's likely that investors would see any group not getting paid as a government default. Lending is about trust. If you see a defense contractor not getting paid for services it's already delivered, would you trust the U.S. government's creditworthiness? You probably wouldn't. And neither would the bond market.

If the bond market loses trust, it may stop agreeing to roll over old Treasuries into new bonds. Then, the Treasury might not have enough money to repay bond principal, let alone interest. Tim Geithner mentioned this threat last year:

In August of [2011], for example, more than $500 billion in U.S. Treasury debt will mature. Under normal circumstances, investors who hold Treasuries purchase new Treasury securities when the debt matures, permitting the United States to pay the principal on this maturing debt. ... [I]f investors chose not to purchase a sufficient volume of new Treasury securities, the United States would be required to pay the principal on maturing debt, and not merely the interest, out of available cash. Yet the Treasury would be unable to make these principal payments without the continued confidence of market participants willing to buy new Treasury securities.

There's no telling what would happen to markets if the debt ceiling isn't raised, but the odds are high that it would be some form of panic, almost certainly sending the economy back into a recession (which, ironically, would worsen the deficit). Ben Bernanke put it politely: Not raising the debt ceiling "would no doubt have a very adverse effect very quickly on the recovery. I'm quite certain of that."

If Congress doesn't raise the debt ceiling, is there a reasonable Plan B?
Two options have been proposed that would let the Treasury borrow more even if Congress doesn't raise the debt ceiling.

One is to invoke a clause in the 14th Amendment and challenge the constitutionality of the debt ceiling. But as President Obama said last year, "My lawyers ... are not persuaded that [the 14th Amendment] is a winning argument." Press Secretary Jay Carney put it more bluntly: "This administration does not believe that the 14th Amendment gives the president the power to ignore the debt ceiling -- period."

Another is the so-called "platinum coin" option, where the Treasury exploits a law that lets it mint special-edition platinum coins in any denomination. In theory, it could mint a trillion-dollar platinum coin and cash it in at the Federal Reserve, thus creating enough money to pay its bills without borrowing more. As long as the Fed sold enough bonds to soak up the new cash created, it wouldn't lead to extra inflation.

Is the platinum coin option ridiculous? Of course. But so is voluntarily defaulting on our debt.

If we don't raise the debt ceiling, is the U.S. bankrupt?
No. The debt ceiling is a self-imposed limit, and this is a self-imposed crisis. Global markets are more than willing to keep lending the U.S. government money at very low interest rates. Congress can end this nonsense as soon as it wants to. 

Ronald Reagan gets the last word: 

The country now possesses the strongest credit in the world. The full consequence of a default -- or even the serious prospect of default -- by the United States are impossible to predict and awesome to contemplate. Denigration of the full faith and credit of the United States would have substantial effects on the domestic financial markets and on the value of the dollar in exchange markets. The nation can ill afford to allow such a result. The risks, the costs, the disruptions, and the incalculable damage lead me to but one conclusion: The Senate must pass the legislation before the Congress adjourns.

The article Everything You Need to Know About the Debt Ceiling originally appeared on Fool.com.

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