Regulatory: The Debt Ceiling Approacheth

John Cooney Now that the threat of a government shutdown has passed, disagreements over the country's fiscal policy will be channeled into debates over raising the debt ceiling. The political maneuvering over this issue could jeopardize the country's single greatest asset--the willingness of other countries to do business in our money.

The debt ceiling is established by a statute that caps the authority of the treasury to borrow money to finance budget deficits. Relatively few countries have such self-imposed limits on their ability to borrow, for most countries, their ability to borrow is determined by the market, through the rate of interest that lenders demand to buy its bonds.

The debt ceiling does not control agencies' ability to spend money, but limits only treasury's ability to borrow to pay our debts. Since the deficit may exceed $1 trillion this year, a tidal wave of bills will be presented for payment. The treasury will reach the debt ceiling in early summer, after it expends the tax revenues received on April 15th and June 15th. Unless the debt ceiling is raised by then, the treasury will have no cash and no ability to borrow money to pay these bills. The U.S. would default on its debts, both foreign and domestic.

The government has defaulted on its debts twice before, when the dollar was not the world's reserve currency. In 1862, to finance the Civil War, the government stopped paying gold for domestic debts but instead issued greenbacks, paper notes that Congress made legal tender in place of gold. The government, however, continued to pay principal and interest on its bonds in gold, and Congress dedicated tariff revenues (payable in gold) to fund these obligations. The United States thereby maintained some ability to borrow abroad, and in 1878, we resumed paying all debts in gold. In 1933, as part of the anti-Depression effort, the government finally abandoned the gold standard and drastically reduced the amount of gold it would pay for a dollar of indebtedness. This partial default on our obligations was an important component of the government's soft money policy to facilitate economic recovery.

It is difficult to predict the consequences if the debt ceiling is not raised and the issuer of the world's reserve currency defaults. Debt and currency markets would face an unprecedented crisis. The price of U.S. bonds likely would fall significantly, and the interest rate demanded on future borrowings would increase dramatically. The value of many other assets, including those that financial institutions must mark to market, also would be compromised.

For a few days, the treasury could try to limit the collateral damage by prioritizing its cash flow to repay principal and interest on government bonds. But these steps would be a palliative; default could be avoided only by passage of new legislation raising the debt ceiling. By the time the treasury was reauthorized to borrow, substantial damage would already have occurred. The government would have undermined the reliability of its currency and its status as a reserve currency. Creditors would reduce their willingness to hold and conduct transactions in dollars, and lenders would demand higher interest rates for dollar borrowings, to reflect the "country risk" of lending to a government whose dysfunctional political system had precipitated a default.

John F. Cooney is a partner in the Washington, D.C., office of Venable.

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