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Demystifying the Debt Limit
By Christopher M. Russo
It’s that time (again) in Washington. For what seems like the umpteenth time, the U.S. government stands on the edge of a fiscal cliff. Meanwhile, political brinksmanship threatens to push us over the edge. Sound familiar?
If some agreement isn’t reached, and soon, we’ll witness the first sovereign debt default in U.S. history. And it wouldn’t be pretty. Like Wile E. Coyote, imagine the world economy going SPLAT.
While at the New York Fed, Christopher Russo forecasted government finances and advised officials on the debt limit. In a new Q&A, he explains what you need to know about the debt limit.
What is the debt limit?
Congress and the president set spending and taxes. Given that budget, it is the responsibility of the U.S. Treasury to collect taxes, pay the government’s bills and make up the shortfall with debt. The debt limit (AKA the debt ceiling) is a statutory limit on the amount that the U.S. Treasury can borrow.
Why do we have a debt limit?
The debt limit helps Congress oversee the U.S. Treasury Department. It is not a check on the power of Congress to spend and borrow. A little history might help explain.
The United States Constitution empowers Congress in two important ways. The Spending Clause vests Congress with the authority to tax and spend. The Borrowing Clause vests Congress with the authority to “borrow Money on the credit of the United States.” As we learned from Schoolhouse Rock, Congress exercises its powers by passing bills. If the president signs a bill (or Congress overrides his veto), then it becomes a law.
In 1789, the 1st United States Congress created the U.S. Treasury to aid in its exercise of these powers. Back then, just like today, the Treasury played a central role in managing revenue and making government outlays. However, unlike today, Congress did not authorize the Treasury to independently borrow. Until 1917, the Treasury required specific legislative authorization to issue new debt. That meant a new law was needed each time the Treasury issued new debt securities.
Congress changed this system during World War I. The tremendous increase in government spending made it impractical for Congress to micromanage debt issuance. For the Treasury to manage the national debt without a per-issue authorization, Congress implemented limits on different types of borrowing. In 1939, on the eve of World War II, Congress consolidated these limits into today’s single “debt limit.”
What happens when the debt limit is reached?
The Treasury can continue to finance the government for a limited time using “extraordinary measures.” These legal loopholes were intentionally created by Congress. They allow officials to continue to issue debt by shifting around intragovernmental IOUs that also count toward the limit. For example, the government can “underinvest” in the retirement benefits of federal employees. (The Treasury replaces the lost interest income once the debt limit is raised, as required by law.)
Keep in mind, extraordinary measures do not reduce the government’s outstanding or incoming bills. While the Treasury can temporarily slash debt issuance to stay under the limit, it will still be required to meet all existing obligations using its limited cash. That cash will run out eventually. Treasury Secretary Janet Yellen recently projected that this “X Date” will occur in October. However, these forecasts are highly uncertain. It might come sooner than expected.
What options are on the table to avoid default?
Because they control the executive branch and both chambers of Congress, Democrats can raise the debt limit as part of budgeting legislation. This “budget reconciliation” process bypasses the Senate filibuster and only requires a simple majority vote to pass. If Democratic congressional leaders can whip together a party-line vote, they don’t even need Republican support.
Alternatively, Democrats can seek to suspend the debt limit for a period. The most recent suspension was passed in 2019 under President Trump and a Republican-majority Senate. However, Democrats would need at least 10 Senate Republican votes to bypass the Senate’s 60-vote filibuster threshold. But with most Senate Republicans vowing not to support the effort, suspending the debt limit might require major concessions.
What would happen if the U.S. did default on its obligations?
Brian Sack, then-manager of the Fed’s securities portfolio, explained the economic consequences to Federal Reserve policymakers in 2013. Interest rates on Treasury debt would rise because U.S. debt would no longer be considered “risk free.” Moreover, the dollar’s value would weaken against other currencies and U.S. assets (like stocks and corporate bonds) would decline in value. There could also be a dangerous risk to our broader financial system, which relies on Treasury debt as a safe store of value.
To be clear, the world’s investors expect Congress to act in time once again. Still, these episodes of brinksmanship harm the government’s credit and credibility. In 2011, Democratic President Obama and congressional Republicans narrowly avoided default. That led to the first credit downgrade in U.S. history. In the words of the current Federal Reserve Chairman Jay Powell, it was a “self-inflicted wound.”
During these debt limit impasses, the government also exposes the nation to serious emergencies. As the Treasury runs down its remaining cash balances to pay bills, it may not have enough cash on hand to respond to terrorism or natural disasters. In a worst-case scenario, the Treasury might temporarily lose access to debt markets. In that case, the Treasury would be unable to raise new funds even if the limit were immediately raised.
Couldn’t the Federal Reserve just save us?
No. As I’ve described before and as discussed by Powell in 2013, the Fed would take several actions in the event of a U.S. sovereign default. However, these steps can only partially mitigate the fallout. Most controversially, the Fed could buy up the defaulted Treasury debt so long as it expected that the payments were only “delayed.”
Powell described this option as “loathsome.” Then-Richmond Fed President Jeffrey Lacker called it “beyond the pale.” Why their reluctance? As Powell explained, “The institutional risk would be huge. The economics of it are right, but you’d be stepping into this difficult political world and looking like you are making the problem go away.”
Is there a long-term solution?
Earlier this year, I argued that Congress should marry a permanent suspension of the debt limit with long-term budget fixes and economic reforms to grow the economy. Unfortunately, this time around, there’s just not enough time to make a comprehensive deal. Still, I’m cautiously optimistic that Congress can take a first step to fiscal sanity.
Even so, we should acknowledge that using the debt limit as a bargaining chip has failed to reign in government spending. We shouldn’t be too surprised. Remember, the debt limit was created to help Congress oversee the Treasury’s debt management, not to limit the growth of government spending. In other words, it’s a way for Congress to check the power of the executive branch, not to limit its own power.