What Happens If The Debt Ceiling Isn’t Raised?

There has been a lot of attention in the news about the potential impact on our economy if the U.S. debt levels reach the debt ceiling limit of $14.3 trillion and the limit it is not raised. As of now, the debt is expected to reach the limit by August 2nd of this year. If this happens, some are concerned that the U.S. could default on its debt obligations to borrowers if the ceiling is not raised, potentially causing a downgrading of U.S. debt and/or starting another economic crisis. To help offset some fears, I wanted to provide some insight to explain the situation.

The U.S. public debt is how much the federal government can borrow and consists of two components:

1. Public debt: the amount of debt held by institutions or individuals outside the U.S. Government (e.g. China).
2. Intragovernmental debt: the amount held in accounts held by the U.S. Government, such as the amount due to fund Social Security benefits.

As of February 2011, public debt was $9.6 trillion and the intragovernmental debt was $4.6 trillion. Defaulting on the public debt piece could potentially have the most significant negative consequences of downgrading U.S. debt or increase fears about our ability to repay our lenders. This would be somewhat similar to not paying your mortgage or credit card bill.

What is the debt ceiling? It is the legal limit of U.S. public debt established by Congress. If Congress does not increase the limit, the Treasury cannot borrow any additional funds to pay bills. The Treasury Secretary, Timothy Geithner, and the administration would have to decide which bills to pay and which to delay. Similar to private corporations and households trying to budget their income and expenses, hard choices would have to be made regarding where to allocate available money.

If the debt ceiling is not raised, the most likely course of action would be to first pay the interest on the debt we owe to borrowers to ensure the U.S. did not default. The next decision would be to determine which government programs and departments to fund. Considering that the current annual interest on the debt is approximately $2.1 billion and the government takes in approximately $2.5 trillion each year, there shouldn’t be a lack of cash to pay the interest due to borrowers. 
Additionally, there is enough revenue coming in to cover Social Security and Medicare benefits, defense and some other programs. The areas that are vulnerable are those that fall under discretionary spending. Please refer to the chart below from the U.S. Treasury department.

During the next few weeks, it appears that if a deal to raise the debt ceiling is reached, it will include an agreement with some level of spending cuts. If no deal is reached, then the government will be forced to decide which bills to not pay. Either of these outcomes will incorporate some type of limitation in government spending. While not paying some of the bills could be viewed unfavorably, a reduction or halt in spending, even temporarily, could be looked upon favorably by foreign borrowers, rating agencies and the stock market as an indication that the U.S. government is taking steps to control its spending.

I hope this helps to bring some understanding about the situation and alleviates any fears or confusion from what is being reported.

Please call me if I can be of any help.

Thank You

Mike