Debt ceiling explained: definition and how it works

Congress building
Rebecca Cattlin
By :  ,  Financial Writer

The US hit its debt ceiling in January 2023, so what happens next? Take a look at what the cap does, and how the debt ceiling is raised.

 

What is the debt ceiling?

The debt ceiling is a legislative maximum that the US Treasury Department is allowed to borrow by issuing bonds. It’s also known as the debt limit or statutory debt limit.

 

How does the debt ceiling work?

The debt ceiling works by measuring the government’s current levels of debt and spending against the limitations imposed upon them.

The cap is set by Congress and currently stands at $31.4 trillion. It was last extended in December 2021 by $2.5 trillion and was expected to last until January 19th 2023 – which is exactly when it was hit.

Now that the ceiling has been reached, the Treasury Department will have to take measures to prevent the government from defaulting on its loans until the ceiling is raised again.

Some of these measures include suspending new investments and making amendments to the Thrift Savings Plan for federal employees – this invests in non-marketable securities with daily maturities. Or, the Treasury can temporarily cease reinvestments altogether and prioritise existing payments.

Usually, the programmes that go first are social security, healthcare coverage for military personnel and other veteran benefits.

 

Why does the debt ceiling matter?

The debt ceiling matters because without a new limit being negotiated, the US could be at risk of defaulting on its loans. As the US Congress and government are at odds, there are concerns that the raising of the limit could be delayed.

A US default would have devastating and wide-reaching effects. It would be the first time in history that the US government has defaulted on its loans.

The US Treasury is currently undertaking extraordinary measures to meet its current debt obligations, but experts have said this can only last a few months.

The US government is expected to run out of cash in June and would default in July or August in what’s being dubbed the X date.

 

What does raising the debt ceiling mean?

Raising the debt ceiling means the government can take on more loans. But it does not mean new spending commitments can be authorised, it is only to finance existing obligations.

 

Can Congress raise the national debt ceiling?

Yes, Congress can raise the debt ceiling. However, as Republicans have control of Congress, it’s likely to be used as political leverage to demand big budget cuts.

The stand-off between the Democratic government and Republican Congress isn’t unusual. It also happened during the Obama presidency. But this game of chicken has a time limit until the X date, so negotiations will need to be quick

It’s not just Congress that could make things difficult though. Biden has said that the debt limit will be raised “without conditions” and the administration doesn’t intend to negotiate.  

 

What happens if they don’t raise the debt ceiling?

If they don’t raise the debt ceiling, it’s likely the US would default on its loans which would have serious consequences for both the domestic and global economy.

The US could be expected to see growth shrink by as much as 5% annually, while nearly 3 million jobs could be lost – according to a think-tank called the Third Way. Meanwhile, the US dollar would weaken and cause borrowing costs to spike. So, for the average American, the interest rates on mortgages and credit cards would rise and retirement pots would shrink.

A default would also have a long-lasting impact on the bonds market. US debt securities are regarded as some of the most secure investments in the world, given they’re backed by the largest economy. However, should the government default, its reputation would be in tatters.

The situation would have knock-on effects on other markets, such as US stocks and indices, as well as global financial markets given how reliant other economies are on the US.

How many times has the debt ceiling been raised?

The debt ceiling has been raised 78 times since 1960. Congress has never failed to raise the debt limit when called upon, although as mentioned, it’s always a political bargaining chip.

 

 

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