Everything you ever wanted to know about the debt ceiling, but were afraid to ask

Sometime in early to mid April the United States government will run up against the limit of what it can legally borrow. The so-called “debt ceiling” will be hit and without an increase, the Federal government of the United States will not be able to pay its bills unless it resorts to drastic measures such as huge tax hikes and/or spending cuts. (More on that later.)

What is the debt ceiling?

The debt ceiling is a limit on what the government can borrow. It was created back in 1917, which was back in the time when we were still on the gold standard. Under a gold standard the quantity of money that the government could issue was essentially fixed. It depended on the amount of gold reserves we held because gold “backed” our money. If the government issued all the money it could under the gold constraint, but needed more, it would literally have to borrow. Congress created the debt ceiling as a way to limit government spending and borrowing.

In 1933, however, we went off the gold standard domestically and in 1971 Richard Nixon took us off of it for international payments as well. That meant gold no longer backed our money and the spending constraint was removed. Nowadays, when the government needs to spend it does so by merely crediting bank accounts. (Changing the numbers in your bank account.) Under this system the debt ceiling has really become an anachronism—a relic of a bygone age. So why do we still have to go through this dance every year or so?

Because of one little technicality.

To understand why the debt ceiling is still an issue you first have to understand how the government and the Treasury operate. The U.S. Treasury (the financial arm of the U.S. government) has an account at the Federal Reserve just like you have a checking account at your bank. Under rules that have been in place since the time when we were on a gold standard, the Treasury is precluded from running a negative balance in its account at the Fed. (The U.S. Treasury has no overdraft line of credit!!) This means when the Treasury’s checking account at the Fed gets drawn down to a certain level and cash needs arise, it must sell some bonds to raise the level of its cash balances. If it didn’t do this then technically, under the rules, it cannot continue to spend.

But is the U.S. government really limited in what it can spend?

Under the authority granted to it in the Constitution the government has monetary sovereignty and the power to issue currency. The Constitution places no limit on the spending power of the government, but it does require that the government make good on all its debts. Hypothetically, that means the government can spend whatever it wants, but because of this arcane and outdated rule, we have to go through this ridiculous debt ceiling dance every couple of years.

Can the U.S. default?

The United States has never defaulted on its debts and technically, it is not even possible because all of our debts are denominated in dollars and the United States government is the sovereign issuer of the dollar. However, there is a difference between the ability to pay your debts and the willingness to do so. Just because you have the money to pay doesn’t mean you are willing to pay. Any entity can default if they are not willing to pay what they owe.

To raise or not to raise…

This is the crux of the current debate that is raging along partisan lines in Congress. Some members believe that it is the duty of the U.S. to pay its bills and therefore, the debt ceiling should be raised without delay. Meanwhile, other members think that the spending has gone too far and the debt ceiling should be capped indefinitely even if it means putting the U.S. in default. So the prospect of default come mid April is very real given the current political and ideological environment.

It will likely go down to the wire.

If the debt ceiling is not is not raised we could still avoid a default, but Congress would have no other choice than to implement a series of very rapid and very large tax increases and spending cuts to close the gap. The Congressional Research Service estimates that the government will need an additional $732 billion above what it expects to receive in taxes and fees in order to cover expenses over the next six months. Spending and tax cuts of that size and in such rapidity would absolutely crater the economy.

Hopefully, cooler head will prevail and we will avoid the Doomsday scenario, but one thing looks certain: it will go down to the wire in a very huge and very scary game of brinksmanship.