Pin Me

How Does the Debt Ceiling Affect You?

written by: N Nayab•edited by: Jean Scheid•updated: 7/28/2011

The debt ceiling is a self imposed limit on borrowings, or the maximum borrowing power. As the national debt ceiling reaches alarming proportions, individuals and businesses seek to understand how the debt ceiling can affect their lives and businesses.

  • slide 1 of 6

    National Debt Ceiling Explained

    What is the Debt Ceiling The U.S. national Debt Ceiling refers to the maximum amount the government chooses to borrow at any given time. The United States enacted a law in 1917 to cap the maximum federal debt. This debt ceiling has been revised many times and now stands at $14.3 trillion. The cap is, however, self-imposed and in reality, the government can borrow while people and financial institutions oblige by lending. At present, the federal government plans to do just that.

    The federal government spends more money than what comes in as revenues, and bridges the difference by borrowing money. Interest repayments on earlier borrowings widens the deficit. Since the accumulated borrowings now touch the legislated debt ceiling of $14.3 trillion, the option before the government is balancing the budget or raising the debt ceiling. Failure to do either would mean a stop to borrowing and hence defaulting on earlier loan repayments and bills. All these three eventualities: raising the debt ceiling, balancing the federal budget, and default will affect businesses.

  • slide 2 of 6

    Default

    If the government does not raise the debt ceiling or balance the budget to ensure that income matches expenditures, the government will not have any money left to pay back earlier loans or settle its bills. Such a default would devastate both the U.S. as well as the global economy and capital markets. U.S. Treasury bonds, the instrument through which the federal governments raise loans, would cease to enjoy the hitherto status of a risk-free asset. Institutional investors would sell these bonds and show reduced interest in buying them. This leads to credit supplies and consequently higher interest rates.

    The trickle-down effects of a spike in interest rates would impact all players in the economy, but especially businesses. Businesses would find making loans for property, plants, and equipment costly. The ensuing cash crunch would put pressures on wages, further tightening the money supply and ultimately, demand. Reduced demand would lead to job losses, leading to a vicious cycle of recession or depression.

  • slide 3 of 6

    Balancing the Budget

    What is the Debt ceiling The reasons for the national debt soaring to unprecedented highs are the combination of costly wars, new tax cuts, and economic stimulus packages, and decreased tax revenues during the recession. The options to balance the budget include sharp cuts to government-funded programs and / or major tax increases. Cutting spending on commitments may have the same effect on default, and as such, the obvious target of expenditure cutting is discretionary spending, which is about 40 percent of the budget.

    Balancing the budget means raising fresh revenue, cutting down on expenditures, or both. Both expenditure cuts and higher taxes would reduce the cash in the market, resulting in a slowdown. Cutting discretionary spending such as defense service and infrastructure development, could result in layoffs. Increased unemployment results in reduced demand for goods and services, leading to another vicious cycle of depression or recession. Reduced demand for good and services could also translate to tighter terms of credit to the corporate market.

  • slide 4 of 6

    Raising the Debt Ceiling

    The anticipated extra borrowings required through year 2012 are $2.2 trillion, and lawmakers would have to increase the debt ceiling by a corresponding amount. Raising the debt ceiling makes available funds to avert default, but works only as a short term measure. Regardless of what the government may fix as maximum permissible cap for federal borrowings, the debt ceiling is ultimately what creditors are willing to lend. As debts mount, institutional investors would begin to doubt the government’s repayment capacity. The reduced availability of funds and increased perception of risk would increase interest rates.

    Most businesses favor raising the debt ceiling as it preserves the status quo and averts the ominous consequences of default or a tighter cash supply. Raising the debt ceiling, however, works only as a short term measure, and balancing the budget is the only viable long term fix. The challenge is to do so without the negative side effects.

  • slide 5 of 6

    Individual Debt Ceiling

    Individuals and companies may look at what is the debt ceiling from a micro-level perspective of limits on their borrowing capacity. In such cases, the debt ceiling is function of market forces. Unless the individual or company voluntarily fixes a lower limit, the ceiling is the limit at which lenders refuse to extend further loans.

    Assume a company pledges its assets to borrow $100,000. The bank may assess the company’s assets and earnings at $150,000, and may extend a further loan of $5,000, but refuse to extend a third loan for $2,000. Thus, $15,000 becomes the company’s debt limit. Such debt ceiling limits availability of funds from lenders, and businesses wanting more money would either have to curb expenditures, or look at other sources of financing such as equity.

  • slide 6 of 6

    References

    1. The Washington Post. “Congress hears outcry from business lobby on debt ceiling and deficit.” http://www.washingtonpost.com/business/congress-hears-outcry-from-business-lobby-on-debt-ceiling-and-deficit/2011/07/12/gIQAiVGpAI_story.html. Retrieved July 13, 2011.
    2. "What’s the debt ceiling, and why is everyone in Washington talking about it?" http://www.washingtonpost.com/business/economy/whats-the-debt-ceiling-and-why-is-everyone-in-washington-talking-about-it/2011/04/15/AFSS4R1D_story.html. Retrieved July 13, 2011.
    3. Tuck School of Business. "Up Against the Debt Ceiling." http://www.tuck.dartmouth.edu/news/articles/the-risks-of-not-raising-the-debt-ceiling/. retrieved July 13, 2011.
    4. “The Debt Ceiling, Explained.” http://www.npr.org/blogs/money/2011/04/12/135314575/the-debt-ceiling-explained. Retrieved July 13, 2011.

    Image Credits:

    1. freedigitalphotos.net/grant cochrane
    2. freedigitalphotos.net/danilo rizzuti