Monday, November 24th, 2014

Ten questions about the debt ceiling

Here's a primer on the debt ceiling, and what can happen if the United States bumps up against it in the coming days.
Here's a primer on the debt ceiling, and what can happen if the United States bumps up against it in the coming days.

For something that could have a profound effect on the nation’s economy, the debt ceiling is a pretty arcane topic. But not much longer! Here are 10 questions and answers designed to shine some light on the subject.

1. So, what is this "debt ceiling"?

The debt ceiling constrains how much debt the federal government can carry at a given time in order to pay for its operations. The debt limit is not new. In the 19th century, Congress approved every individual sale of bonds to the public. But beginning in 1917, Congress started to distance itself from the nuts and bolts of issuing debt, letting the Treasury Department decide when and how to auction bonds, but retaining the right to set an overall debt limit. Whenever the amount of debt approached this limit, Congress would need to vote to raise it.

That’s where we are today — the amount of federal debt is once again approaching its legal limit, meaning that if Congress fails to raise it, the nation won’t be able to borrow any more money to finance the existing financial commitments Congress and the president have agreed to. For months, the Treasury has used "extraordinary measures" — essentially, shifting around accounts in order to keep more cash available for payments — but these measures are expected to run out in mid-October.

2. Wait, so this affects debts we already owe?

Yes, we would need to raise the debt ceiling to borrow funds for the obligations the federal government has already incurred. "If the U.S. reaches the debt cap and Congress does not approve further borrowing, then the government will not be able to fulfill all of their obligations as agreed to in the most recent budget," said Tara Sinclair, a George Washington University economist. "Some law will be broken — either the debt ceiling will be breached or the budget will not be honored."

But it goes beyond that: If the debt ceiling isn’t raised, it could also affect our ability to pay future obligations. Officially, Congress and the president are the ones who must sign off on any new federal commitments. But if the debt ceiling isn’t raised, and if not enough progress is made on paying down the existing debt, Congress and the president would find their hands tied if they want to make any new financial commitments.

3. Then what’s the difference between the "deficit" and the "debt"?

Every year, the federal government either runs a surplus or a deficit. When there’s a surplus, it means that more money came in than was spent. When there’s a deficit, it means that more money was spent than came in. Deficits are typically calculated on an annual basis. But if you add up all the past deficits (and subtract all the past surpluses), the resulting figure, if it’s negative, is the "debt." Unlike deficits, which start fresh every year, the debt is cumulative and continuous.

4. I’ve heard about "public debt" and "intergovernmental debt." What’s the difference?

"Public debt" includes Treasury notes and other securities that are sold to investors. "Intergovernmental debt," by contrast, is debt held by the government, often in the form of surpluses from the Social Security and Medicare trust funds that are invested in Treasury securities. As the Government Accountability Office has put it, "debt held by the public represents a burden on today’s economy, as borrowing from the public absorbs resources available for private investment and may put upward pressure on interest rates," whereas intergovernmental debt amount to IOUs that reflect "a burden on taxpayers and the economy in the future."

5. How do people or institutions or other governments actually "buy" U.S. debt?

If you hold a savings bond your grandmother gave you on your 10th birthday, or if you go to www.treasurydirect.gov to purchase Treasury bills, then you are loaning money to the government, with the promise of receiving your principal plus interest at a specified future date. Alternately, if your mutual fund buys a Treasury bill, you indirectly own that security. Investment banks, sovereign wealth funds and other large investors purchase Treasury debt all the time in auctions held by the Treasury. If you hold a U.S. security in this way, "it means that you have loaned money to the U.S. government, and it has borrowed from you," said Neil H. Buchanan, law professor at George Washington University and author of The Debt Ceiling Disasters.

6. To whom (or what) does the United States actually owe this money?

More than two-thirds of the United States’ debt is held in the United States, either directly by individual bondholders or by institutions, such as mutual funds or retirement plans. The remaining third is held by foreigners, either individually or institutionally. Of that one-third held by foreigners, almost 23 percent is held by Chinese individuals or institutions and 20 percent is held by people or institutions in Japan. Investors in dozens of other countries hold some U.S. debt, but no single country other than China and Japan holds more than 5 percent of the foreign total.

7. What actually happens if we hit the debt ceiling?

Once the debt ceiling is reached, the federal government is no longer able to issue debt (that is, borrow from investors by issuing bonds and notes). That’s predicted to happen in mid-October . At that point, the government would have a little breathing room to send out payments — it could use the cash it already had on hand, plus any new revenue it received in the interim. But that cash supply is not expected to last beyond Nov. 1 at latest.

So what happens then? The most obvious solution (beyond simply doing nothing) is to prioritize payments. Bondholders would likely be paid off first, since a missed or delayed payment on a financial instrument would entail the most severe peril for the government. Outraging senior citizens by delaying or missing a Social Security check is bad enough, the thinking goes, but if investors decide en masse to abandon U.S. bonds in the future, it would put the entire stability of the federal government’s finances (and ultimately, the U.S. economy) at risk.

But prioritization has problems, experts say. For one thing, the federal government’s computer systems are not set up to do this, meaning it might not be a practical option (and could result in costly errors). In addition, the Treasury says it’s not clear it would have the legal authority to make those sorts of decisions. And it could cost more, since the law requires the government to pay interest on top of any payments that are delayed.

It’s also not clear whether prioritizing bondholder payments would keep the United States from a "default." It all depends on how you define the word "default." Some lawmakers who downplay the consequences of hitting the debt ceiling argue that a default only happens if interest on securities isn’t paid. A missed payment to a federal contractor or a Social Security recipient, according to this argument, doesn’t trigger a default.

The nonpartisan Congressional Research Service has acknowledged that there’s no clear answer to this question, but it does note that Black’s Law Dictionary defines the term "default" as "the failure to make a payment when due" — a definition that does not restrict a default to a missed interest payment. Ultimately, CRS notes, "financial markets’ perceptions of what constitutes a default, or a real threat of default, may be more relevant when assessing the potential impacts of not raising the debt limit."

8. Given how oddly our government has been acting lately (think "government shutdown") why is our debt still so sought after?

In large part this is because a default — even a partial one, for particular payments — has been so unthinkable for so long. "Markets still believe that, when push comes to shove, the U.S. will not default on its obligations," said Buchanan, the law professor.

People need to put their money somewhere, and given the long track record of its securities, as well as its overall economic strength, the United States is still considered a relatively safe place to put money. Pension funds, for instance, are required to put a certain percentage of their holdings in "safe" assets, and U.S. government bonds have historically been among the most attractive "safe" places.

"Our currency is in high demand, and our debt is the form in which the world holds our currency," said Anna Gelpern, a law professor at Georgetown University and coauthor of Is U.S. Government Debt Different? "There are not many good alternatives."

Ironically, even after the United States experienced a major financial crisis and recession in 2008, demand for Treasury securities was high. "The world — and China’s extraordinary, though decreasing, savings — have been for several years seeking safe assets, and as the crisis raged on, including and especially in Europe, there were fewer options for safe asset investments," said Satya Thallam, director of financial services policy at the American Action Forum, a center-right think tank. "U.S. debt, despite policymakers’ erratic behavior and long-term concerns over debt sustainability, was still one of the few options that provided the necessary volume of safe assets."

9. Would U.S. debt still be in high demand if we hit the debt ceiling?

A recent Pew Research Center poll found that a majority of Republicans agreed with the statement that "the country can go past the deadline for raising the debt limit without major economic problems." Some economists agree with that view, but not many.

While we won’t know for sure unless we actually hit the debt ceiling, most economists expect some investors to take their money elsewhere. "The expression 'bond vigilante’ " has a basis in reality, Thallam said. An actual default on interest payments would be the worst-case scenario, but even a default on other federal obligations could be enough to spook bond buyers. And if enough investors go elsewhere, that means the United States would have to offer higher interest rates to lure their money back, raising the government’s borrowing costs in ways that would sooner or later filter throughout the economy.

Even an inability to pay certain obligations other than interest could set off a change in investor confidence that would make them less willing to buy U.S. Treasuries, Buchanan said. "This isn’t a prediction by partisan politicians, but by many cold-blooded financial market analysts," he said.

10. And, last but not least: How would ordinary Americans be hurt?

Most directly, an "ordinary American" who owns any stocks or bonds — even if the bonds are not from the U.S. government -- will see the value of those investments drop. This includes the values of mutual funds, IRAs, pensions and 401(k)s.

Those who do not lose wealth directly through such investments will likely experience a broader economic downturn, for two reasons, Buchanan said. First, he said, businesses and individuals will become hyper-cautious. And second, failing to pay the people who were to receive those defaulted-upon obligations will have less money to spend.

The average American will also likely see interest rates go up as the Treasury has to hike rates to attract investors. This would make interest rates higher for mortgages, car loans, student loans and credit cards. As businesses find it more expensive to borrow, they would stop hiring and start laying people off; house prices would fall and retail sales would drop. The newly unemployed would have less money to spend, reinforcing the negative spiral. Taxes may have to rise, at least eventually, due to the government having to pay substantially higher interest rates on existing debt.

And because U.S. Treasuries quietly underpin much of the nation’s (and the world’s) economic and financial systems, anything that disrupts confidence in Treasuries would likely throw the banking sector into turmoil. This could reverberate throughout the world. "Many economists and financial institutions," the Congressional Research Service has said, "have stated that if the market associated Treasury securities with default risks, the effects on global capital markets could be significant."