WHAT THE HELL IS THE DEBT CEILING?

Sarah,

The US debt ceiling is always in the news.  What the hell is it?  Further, what is debt?  Who owns our debt?  Here is a breakdown:

US Government 101:

The Constitution of the United States divides our government into three sections: the legislature (congress), the executive (the President), and the judiciary (the courts).  Congress makes the laws, the President and his agencies enforce the laws, and the courts interpret the laws.

Each branch is given specific powers.  Congress is explicitly given the power “to borrow money on the credit of the United States”.  Therefore, the theory goes, if part of the government needs to borrow money, congress has to approve that borrowing.  The Environmental Protection Agency, for example, falls under the executive branch because it is tasked with enforcing the laws of the United States.  If it needs to borrow money, congress has to authorize that loan.

Quick History:

Before 1917, congress had to approve each individual act of borrowing separately.  When the United States entered World War I, this system became untenable and was replaced with a new system in which congress merely “set a ceiling” on the amount of debt that could be raised.

Since then, the celling has been raised dozens of times.  In 2011 there was a standoff in congress because the debt ceiling of $14.29 trillion had been reached.  To raise the ceiling both parties had to work together; something they aren’t really into.  Democrats demanded tax increases along with cuts to government programs.  The Republicans refused to raise taxes on the theory that such a move would endanger the fledgling economic recovery. 

Predictably, congress failed to reach any sort of long term compromise and instead came to a last minute deal that raised the debt ceiling another 2.4 billion dollars.

The next standoff is due to occur in January of 2013, after the upcoming election.

How Much Debt Are We In?

The word “trillion” sounds made-up and it is hard to conceptualize just how large a trillion is.  It’s easier to think of the debt in relation to our Gross Domestic Product. (GDP)  America’s GDP is the accumulation of all goods and services produced within America in a given year.  Currently America’s GDP stands around $15 trillion.  Our debt is also around $15 trillion.  Thus our debt is about 100% of our GDP.  In other words, our debt is equal to the value of all the goods and services produced by America in one year.  This is the highest level of debt in proportion to our GDP since World War II.  The recent debt is largely due to the wars in Afghanistan and Iraq and Obama’s stimulus program. 

What Is Debt?  Why Is Paying It Back Important?

Our most common form of debt comes in the form of securities issued by the United States Treasury.  Basically, if you buy a security, you get a promise from the government that they will pay you back with interest.  The United States is able to borrow at a very low interest rate because it has never defaulted on any debt.  In other words, buying treasury securities is a very safe investment.

For this reason, it was a big deal when we reached our debt ceiling.  If we passed our debt ceiling, we would have defaulted on some of our loans because we constantly borrow money to service our current debts.  Theoretically this would raise the interest rates on our securities because they would be viewed as “less reliable”.  Further, because most investment portfolios carry treasury securities, a downgrade could cause a financial panic. 

During this crisis of 2011, a credit agency downgraded us from AAA to AA but it did not affect our interest rate because demand for US treasury securities remained strong (in a crisis people want a safe place to invest their money).

Other countries are not so fortunate.  Greece is in a financial crisis and people doubt that they will be able to repay their loans.  Accordingly, it is very expensive for Greece to borrow money.  In the news, you will constantly see headlines about bond sales in Ireland, Spain, or Greece.  The rate at which these countries can sell bonds (debt) indicates how investors view their financial health.  Recently Ireland surprised markets by selling bonds at a lower rate than expected.  This was favorable news for the Irish economy.

Does China Own Us?

You could argue it.

However, it’s not just China; other countries own us too.  50% of our debt is held by other countries.  Both Japan and China hold about a trillion dollars of American debt.

The proportion of our debt owned by foreigners has risen steadily in the last decades.  In 1988, foreigners held 13% of our debt.  In 2007, foreigners held 25% of our debt.  Now the number is around 50%. 

I honestly don’t know if this matters.

Is There In An End In Sight?

I’m not very optimistic.  Congress is incredibly polarized.  The Democrats seem unable to raise taxes.  The Republicans seem unable to effectuate major budget cuts.  Obama has been unsuccessful in cutting the deficit.  Romney promises to cut, but declares that there will be no new taxes and he will increase military spending.  I don’t really understand either party’s math.

Bottom line:  I’m more confused now than when I started writing this post.  We owe also owe Japan a trillion dollars?  What does that even mean?