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Understanding the Debt Ceiling Drama



The debt ceiling is making news again. Will Congress raise it? Will the U.S. make history by defaulting on our government debt?


If it seems like this a story you’ve heard before, that’s because it is. Over the past decade, there have been seven occasions where we’ve seen negotiations (or lack thereof) over the debt ceiling come uncomfortably close to Congress’s deadline to act.


With the window to act ranging from a few weeks to one day before the deadline expires, the drama has varied. We created a short primer on why we end up in this cycle and what it means for investors.


Why Do We Have a Debt Ceiling?


The practice of borrowing money involves the Treasury auctioning securities. Historically, Congress would approve each individual auction by passing a new law. However, with the entry of the U.S. into World War I in 1917 and the need for timely funding, Congress set a borrowing limit, or a 'ceiling', for the Treasury.


How Does the Treasury Determine When Funds Will Run Out?


The Treasury uses a few key pieces of data to determine when it is likely to run out of funds. The biggest parts of the calculation are:

  • How much tax money is likely to be available

  • When will that money arrive

  • When debt payments are due

These factors help establish what the Treasury refers to as the 'X Date'. However, reaching the X Date doesn't automatically trigger a default on debt payments.


The Treasury has a range of 'extraordinary measures'—akin to a government version of looking under the couch cushions for change—to ensure the U.S. doesn't default on its payments to Treasury securities holders. These measures have been in effect since January, but the Treasury estimates they will no longer suffice sometime in June or early July. This estimation sets the deadline for Congress to act.


Why Does This Matter?


If you set up a scheme whereby people invested money with you, and then you gave them returns on that investment that were funded by new money that people invested with you, you’d get investigated by the SEC and most likely go to jail. When individuals do it, it’s called a Ponzi scheme.


The U.S. is the largest economy in the world, and the securities issued by the Treasury are considered “risk-free” because they are backed by the “full faith and credit” of the United States. This refers to the ability of the government to raise money by taxing its citizens and borrowing funds.


If the government were to demonstrate that it does not have this power by defaulting on debt payments, it would certainly mean that future borrowing would become more expensive, and the risk would be much higher.


The implications go well beyond increasing the cost of borrowing. A default on U.S. Treasury bonds would likely trigger a global financial crisis, potentially greater than any we have seen yet.


What Happens if the Debt Ceiling is Extended?


Even if the debt ceiling is extended, the crisis may not completely vanish. Due to the severity of the threat, debt rating agencies might adjust their ratings. This occurred in 2011, when the crisis was narrowly averted but Standard & Poor’s downgraded their rating of U.S. government debt from AAA to AA+.


If debt is downgraded, borrowing becomes more expensive for everyone. U.S. Treasury rates are used to set the cost of consumer debt including credit cards, auto loans and mortgages. They are also used to set the cost of municipal debt – and higher costs of debt may mean higher taxes.


What Can We Do?


Education is key. Learning more about our national debt, the debt ceiling, and the potential consequences of a default can equip us with the knowledge to make informed decisions and be active participants in the conversation. Understanding the debt ceiling crisis requires a shift in our perspective. By staying informed, we can navigate this crisis and use it as an opportunity for growth and improvement.


 

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.


This content not reviewed by FINRA




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