The Debt Ceiling Explained (Kind Of)

You’re bound to eventually hear about this whole debt ceiling situation. If not during this cycle, then perhaps the next one. Because it keeps coming up, making for some great political theater, with the disclaimer that even the greatest political theater is bad art. In any event, let’s take a look. Make that a hazy look.

 

The Concept

In order to meet its financial obligations—things like paying the military, issuing social security payments, and a ton of other stuff—the US government must borrow money. To make this happen, it sells Treasury bonds to all sorts of entities (including foreign governments), generating immediate cash flow that keeps the aforementioned payments on track. Of course, the money must be paid back with interest, but the expectation is that this won’t be an issue—we are talking about the mighty US after all.

Unlike most other countries, the US has a debt ceiling, meaning there is a cap on the amount the country can borrow via such bonds. The cap was initially instituted in the World War I era so the US Treasury didn’t have to ask Congress for permission each time bonds needed to be issued (at the same time keeping the Treasury in check). The debt ceiling has been raised numerous times since then, and at the time of this writing sits at about $31.4 trillion.

Whenever the debt limit needs to be raised, it is, since impeding access to the money that allows the US to meet its commitments—as in paying large sums worldwide—could be disastrous for the global economy. But along the way, tons of debate occurs regarding why the country spends so much money to begin with.

 

Isn’t Debt Bad?

Here’s where things start to get complicated, because regardless of what the all-caps social media types say, running a country is way more complicated than running a little four-person household. On the surface, trillions in debt seems excessive, and having the same exact country without the debt would probably be preferable. That said, unless you want to pay more taxes or see your favorite government benefit flushed down the toilet, that ain’t going to happen. Then the question becomes, how much debt is too much?

 

Debt-to-GDP ratio

One way to answer the question is to look at a country’s debt-to-GDP ratio, i.e. the ratio of a country’s public debt to its gross domestic product. Often expressed as a percent, the higher the number, the greater the risk of default. But again, it’s complicated.

While the World Bank seemed to identify 77 percent as the number that shouldn’t be crossed, a look at countries well above that threshold shows a mixed picture. At a whopping 350 percent, Venezuela isn’t inspiring confidence, but the 266 percent boasted by Japan doesn’t seem to irk many. Similarly, Libya’s 155 percent is cause for concern, but the 128 or so percent sported by the US is met with a few shrugs.

In other words, other factors must be in play. For instance, healthy GDP growth can diminish the angst that comes with debt, whether expressed in absolute terms or as a ratio. Similarly, debt with a low interest rate is less worrisome than the alternative. Finally, the perceived stability of a country and its institutions (such as an independent central bank) is key. Stated another way, fear-mongering politicians should talk less.

 

GDP Growth Rate Versus Interest Rate

Taking the above one step further, as long as GDP growth rate outstrips the interest rate on debt, debt-to-GDP ratio will decrease, even if debt is actually increasing. A school of thought exists that as long as this criteria is met, debt is safe. Clearly, unexpected alterations in GDP growth and interest rates can affect this delicate balance, but the assumption that debt must be limited is at least up for debate.

 

So what’s the bottom line?

a) I don’t know.

b) Americans—particularly the ones who don’t read—will get angry about this stuff.

c) Just watch Netflix.