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Wednesday, July 17, 2024

How the U.S. debt ceiling works

How the U.S. debt ceiling works

04.11.2023

If you follow government news at all, you’ve probably heard talk of the debt ceiling. It seems members of Congress are constantly debating whether to increase it, often with one side accusing the other of overspending. 

But what does it all really mean? To help you gain a greater understanding of what’s happening, we’ll discuss what the U.S. debt ceiling is, what the national debt is, what it means to raise the debt ceiling, and what happens if Congress doesn’t raise the limit. 

What is the U.S. debt ceiling? 

The U.S. debt ceiling — also known as the debt limit — is the maximum amount of money the federal government is authorized to borrow. 

It dates back to 1917 and World War I, when Congress created it to give the Treasury Department greater flexibility to finance the costs of the war. Congress wanted the Treasury department to be able to borrow money for the war up to a certain amount.

As you can imagine, the debt ceiling in 2023 looks a lot different than it did in 1917. Congress has increased the debt limit 78 times since 1960.1 As of early 2023 it sits at $31.4 trillion (which it was raised to in December 2021).

The U.S. national debt 

Now that we’ve covered what the debt ceiling is, let’s back up a step and discuss why the U.S. takes on debt in the first place.

The federal government doesn’t collect enough tax revenue to pay for all of its expenditures. In 2019, for example, incoming revenues only covered about 80% of government spending. The remaining 20% — or whatever the percentage is in a given year — must be covered by borrowing.3

And just like if you used your credit card for 20% of your purchases without being able to pay off all of what you spent, the debt balance rises. 

The national debt hasn’t risen consistently from year to year. There have been a handful of years where the federal government had a surplus, meaning its revenues exceeded its spending. The last of those years was in 2001 during the Clinton presidency.4

On the other hand, there have been years where the national debt has grown more than in other years. Examples of events that have triggered spikes in the federal debt include wars, tax cuts, and stimulus programs. Some notable examples include the wars in Iraq and Afghanistan, the 2008 Great Recession, and the COVID-19 pandemic.

 While the national debt gets some negative attention, it pays for critical programs and services from the federal government. 

“Some examples of expenses the government funds through debt are social security, Medicare, the military, federal employee salaries and pension expenses, and paying interest on existing debt (such as bonds),” said Lacey Cobb, Director of Advice Solutions and Portfolio Management for Empower.

The U.S. generally has two types of debt: that which is held by the public and that which is held by the government itself. Most of the debt — $24.67 trillion compared to $6.79 trillion — is held by the public.

The phrase “debt by the public” is quite all-encompassing, as it includes any debt not held directly by the federal government. Some examples include:

  • Individuals
  • Corporations
  • State and local governments
  • Federal Reserve banks
  • Foreign investors
  • Foreign governments 

The three foreign governments that own the most federal debt are Japan, China, and the United Kingdom.8 

It’s worth noting that many individual investors own some of the $24.67 trillion of public debt the government has. One way the government raises money is by issuing Treasury securities. So if you have any of those securities in your investment portfolio, you are one of the federal government’s many creditors.9

On the other hand, intergovernmental debt is any money the federal government owes itself. Some of the most notable examples include debt owed to programs like Social Security and Medicare, which the government has borrowed against for other expenditures.10 

What it means to raise the debt ceiling 

When it comes to talk of raising the debt ceiling, the first reaction for many Americans is that we should leave the limit where it is so that the government has to stop spending money. But that’s not quite how it works.

First, raising the debt ceiling doesn’t authorize new spending. Congress authorizes spending through legislation, and raising the debt ceiling simply gives the Treasury Department the power to spend the money that has been allocated.

Next, failing to raise the national debt ceiling doesn’t just stop new spending — it also prevents the government from paying for its current expenditures, including critical programs and services.

Finally, raising the debt ceiling also allows the federal government to continue making payments on its current debt. According to the Treasury Department, roughly 12% of federal spending — or about $307 billion — is used to maintain our current debt as of February 2023.11

Imagine if you decided you weren’t going to allow yourself to go into any more debt. And one of the ways you’ll do that is to stop making your credit card payments. Not only would you, in fact, accrue a lot more debt, but you would also do long-term damage to your financial health. 

How the debt ceiling is raised 

The Constitution gives Congress the power to control government spending as well as to limit the amount of federal debt. And because it’s Congress that sets the debt ceiling, it’s also Congress that must raise it. And it has done so more than 100 times since World War II.12

In many cases, Congress has raised the debt ceiling with limited drama or debate. But in more recent decades, the debt limit has become a negotiation tool for the different parties within Congress.

“Ultimately, changes to the debt ceiling require bipartisan cooperation from Congressional leaders to get the necessary votes to make changes,” Cobb said.

When the federal government reaches its debt limit, Congress has three options

  • Leave the debt limit where it is 
  • Increase the debt limit 
  • Suspend the debt limit13

Suspending the debt limit would be a temporary measure until Congress can agree on a plan to raise the debt ceiling, which requires a majority vote in both houses. However, it also sometimes requires overcoming a Senate filibuster, which requires a vote of 60 Senators instead of the usual 51.14 

What happens if we don’t raise the debt ceiling 

As of early 2023, the United States has reached the debt ceiling currently in place. Secretary of the Treasury Janet Yellen has stated the government will use extraordinary measures to continue fulfilling the federal government’s obligations, but those will run out sometime in the summer of 2023.15

That begs the question: What happens if we don’t raise the debt ceiling?

Historically Congress has always raised the debt limit when needed, with a few exceptions. The reason for this is because, even when the debt limit is being used as a negotiation tactic, political leaders understand how important it is to keep the government running.

“Although we believe it will be a contentious debate that likely goes down to the wire, it is highly unlikely that the two parties will be unable to reach an agreement,” Cobb said.

Failing to raise the debt ceiling could have major consequences. Not only would the government not be able to continue to fund many programs and services, but it would default on its debt, which would severely impact its investors, which include U.S. citizens.

Ultimately, not raising the debt ceiling could have major financial impacts, not only on the United States, but on the world.

“The entire US financial system is built on the trust and guarantee of the U.S. government meeting its debt obligations,” Cobb said. “A default would jeopardize the stability of the entire financial system.”

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Erin Gobler

Contributor

Erin Gobler is a money coach who helps people pay off debt and reach their big financial goals without giving up spending on the things they love. She is a freelance writer for Empower.

Author is not a client of Empower Advisory Group, LLC, and is compensated as a freelance writer.

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