How the Debt Ceiling Works

As the Daily Treasury Statement shows, the U.S. federal government spends an obscene amount of money every day to pay for hundreds of programs and services, from national defense to education to disease control and prevention.

The problem is that the federal government doesn't earn enough in income tax and other revenue to cover the cost of running the country. The result is that pesky budget deficit. Technically, Congress could erase the budget deficit by passing steep spending cuts, raising taxes or both, but that has proven politically problematic.

Instead, the government covers the budget deficit by borrowing money. The president doesn't walk down to a Bank of America and ask for a $1 trillion loan. The better way is to sell U.S. Treasury securities to individuals, banks, corporations and even foreign governments. When you buy a Treasury bond, you are essentially lending money to the government at a low interest rate. China and Japan each owned more than a trillion dollars in U.S. Treasury securities as of July 2013 [source: U.S. Treasury Dept.].

When you add up all of the money that the federal government has borrowed from other countries, individuals and even itself (the Federal Reserve owned more than $2 trillion in Treasury securities as of October 2013), you get the national debt [source: Federal Reserve]. The national debt doubled from $5.7 trillion in 2000 to $10 trillion in 2008 and now stands at more than $16 trillion [source: U.S. Treasury Dept.].

Which brings us to the debt ceiling. Some folks compare the debt ceiling to the credit limit on your credit card. If your card has a $10,000 credit limit, then you can only charge $10,000 on your card without paying down the outstanding balance. In much the same way, the debt ceiling is a limit on how much the government can borrow to pay for its programs and services.

But there are key differences between the debt ceiling and a credit limit. The bank set your credit limit because it decided that that it's too risky to lend you more than $10,000. On the flip side, the foreign governments and individuals that buy U.S. Treasury securities can't get enough U.S. debt [source: Hirsch]. To them, it's literally the most reliable investment in the world, backed by the "full faith and credit" of the U.S. government.

In the case of the debt ceiling, the credit limit is imposed by the borrower, not the lender. Congress sets the debt ceiling, not our foreign or domestic creditors. But why would Congress want to lower U.S. debt if the well of low-interest credit never runs dry? To answer that question, we first need to study the history of the debt ceiling.

Camp McCalla in Guantanamo Bay, Cuba, during the Spanish-American War. The War Revenue Act of 1898 helped fund this war and represented the first time the Treasury could borrow up to a fixed ceiling.

Hulton Archive/Getty Images

When the United States was younger, Congress held a much tighter grip on the national "credit card." In most cases, the Treasury could not sell securities — aka borrow money — without explicit approval of Congress. When the Treasury needed to borrow money, Congress determined what types of securities to sell — short-term or long-term — how many, and at what interest rates [source: Austin and Levit].

Strict congressional oversight was lifted temporarily during times of war. The War Revenue Act of 1898, for example, gave the Treasury flexibility to borrow up to $500 million by selling a combination of short- and longer-term securities. This money was used to fund the Spanish-American War and represented the first time that the Treasury could freely borrow up to a fixed limit or debt ceiling.

The First and Second Liberty Bond Acts of 1917 set similar debt limits to help fund the U.S. entry into World War I [source: Austin and Levit]. Gradually, the Treasury was given more and more freedom to determine which securities would generate the most revenue for the least amount of interest.

In the 1920s and 1930s, Treasury Secretaries Andrew Mellon and Henry Morgenthau argued for even more flexibility to manage the nation's debt. In 1939, Morgenthau and President Franklin Roosevelt convinced Congress to create the first aggregate debt limit, meaning a debt ceiling that covered all federal debt [source: Austin and Levit]. As long as the Treasury stayed below that debt limit, it was free to borrow as it saw fit to pay the country's bills on time.

This was the birth of the debt ceiling as we know it. Under this arrangement, Congress approves spending bills and the Treasury figures out how to pay for them. Treasury is allowed to borrow up to the debt ceiling without asking Congress for permission to borrow more. But every so often, Treasury bumps up against the ceiling, and Congress must vote to raise it. Since 1960, Congress has voted to raise the debt ceiling 78 times [source: Sherter].

In recent years, some congressmen and women have threatened to block passage of debt ceiling increases unless cuts were made to government spending. To understand why these threats are so politically powerful, let's look at the potential damage to both the U.S. and global economy if Congress failed to raise the debt ceiling.

To understand what would happen if the U.S. Congress didn't raise the debt ceiling, let's go back to the credit card analogy. If you borrow the maximum $10,000 allowed by your credit card, you will need to do everything in your power to avoid going into default, which would ruin your credit rating. You can try to drastically cut your personal spending, get a second or third job to increase revenue, or borrow the money from someplace else, probably at a higher interest rate.

If Congress decides not to raise the debt ceiling, the federal government runs the same risk of going into default and damaging its credit rating. Up until now, the world has treated the U.S. Treasury like an international piggy bank, the safest place to invest money during an era of global economic uncertainty. When a foreign government needs cash, it can simply redeem a few million dollars in U.S. Treasury bonds.

But what if the Treasury doesn't have enough money to back its bonds? At worst, it could default on some of its debts, which could send global markets into a panic. But even if the government avoids a full default, it could lose its AAA credit rating. That means that creditors could demand higher interest rates. When the base interest rate on Treasury bonds goes up, other interest rates are likely to follow, like those attached to home mortgages or business loans [source: Davidson]. Higher rates would discourage investment, creating a huge drag on economic growth in the U.S.

Also, if Congress opted not to raise the debt ceiling, it would be forced to live within a budget. That would likely mean deep, across-the-board spending cuts and massive scale downs of popular programs like Social Security and Medicare. It would also likely mean raising taxes significantly.

Until those spending cuts and tax hikes took effect, the Treasury would have to decide which bills to pay first with its dwindling funds: interest on the national debt or Social Security payments? Tax refunds or Medicare reimbursements? All of these scenarios would likely trigger a massive political backlash from voters in both parties.

That's our brief explanation of how the debt ceiling has evolved from a convenient instrument for managing government borrowing into a political powder keg. For lots more information on the national debt, personal budgeting and credit cards, check out the related links on the next page.

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Author's Note: How the Debt Ceiling Works

While researching this article, I came across an illustration that encapsulates the whole debt ceiling debate in a single image. A twitching finger — presumably belonging to a rattled Congressman — hovers above two toggle switches. The first, in calming blue, says, "Raise the Debt Ceiling." The second, in alarming red, reads, "No More Debt." If Congress throws the red switch and fails to raise the debt ceiling, the short-term economic shock waves could be violent. Over the long term, it's not hard to imagine a world in which the dollar is no longer the default currency, and the U.S. cedes its superpower status to the Chinas and Brazils of the world. But what about the danger of throwing the blue switch, again and again and again? Is it sustainable to let China and Japan continue to pay our bills? The price of living without debt would likely mean harsh economic austerity and a downgrading of the American dream. It's painful to watch dreams die, but what if the only other option — spending and borrowing ad infinitum — turns out to be an even more dangerous fantasy?

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