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What is the debt ceiling? Why it’s important and how it affects you

  • The debt ceiling is the amount of money the U.S. is authorized to borrow to pay its bills.
  • The U.S. runs a budget deficit, meaning its revenue isn’t enough to cover spending. The government borrows money to make up the difference.
  • Congress regularly suspends or raises the debt limit so the U.S. can borrow more. But lawmakers are at an impasse — meaning the government could default on its debt as soon as June 1.
  • Failing to pay its bills in full and on time may have serious economic repercussions: recession, job loss, delayed payments of federal benefits like Social Security, higher borrowing costs and a plunging stock market.

The U.S. may default on its debt within a month — an event that could threaten severe financial harm for American households and the economy at large, experts warn.

To avoid that outcome, lawmakers are trying to find a path forward to raise or suspend the debt ceiling, which would enable the U.S. to pay its bills on time. But they’re currently at an impasse, raising the prospect of default.

“A failure to do that would be unprecedented,” Jerome Powell, chair of the U.S. Federal Reserve, said during a press conference Wednesday. “We’d be in uncharted territory … and the consequences to the U.S. economy would be highly uncertain and could be quite averse.”

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Here’s what the debt ceiling is, and what makes it so important for consumers.

What is the debt ceiling?

The debt ceiling is the amount of money the U.S. Department of the Treasury is authorized to borrow to pay the nation’s bills.

Those obligations include Social Security and Medicare benefits, tax refunds, military salaries and interest payments on outstanding national debt, for example.

The current ceiling is about $31.4 trillion. The U.S. hit that borrowing limit in January.

Not unlike many households, the government is reliant on debt to fund its obligations.
Mark Hamrick
senior economic analyst at Bankrat

That means the federal government is unable to increase the amount of its outstanding debt — and paying its bills becomes trickier.

“Not unlike many households, the government is reliant on debt to fund its obligations,” Mark Hamrick, a senior economic analyst at Bankrate, previously told CNBC. “And like many households, it doesn’t have sufficient income to fund its expenses.”

The debt ceiling wouldn’t be an issue if U.S. revenues — i.e., tax proceeds — exceeded its costs. But the U.S. hasn’t run an annual surplus since 2001 — and has borrowed to fund government operations each year since then, according to the White House Council of Economic Advisers.

Why is the debt ceiling an issue right now?

U.S. Treasury Secretary Janet Yellen on April 20, 2023 in Washington, D.C.
Anna Moneymaker | Getty Images News | Getty Images

The Treasury has temporary options to pay bills: It can use cash on hand or spend any incoming revenues, like those from the recently concluded tax season.

It can also use so-called “extraordinary measures.” These measures, which basically entail shifting funds around behind the scenes, free up cash for the federal government in the short term. The Treasury started using those measures Jan. 19 when the U.S. hit its $31.4 trillion debt ceiling.

These maneuvers have helped prevent a potential calamity: a default.

A default would occur if the U.S. runs out of money to meet all its financial obligations on time — for instance, missing a payment to investors who hold U.S. Treasury bonds. The U.S. issues bonds to raise money to finance its operations.

The U.S. has defaulted on its debt just once before, in 1979. A technical bookkeeping glitch resulted in delayed bond payments, an error that was quickly rectified and only affected a small number of investors, the Treasury said.

We’d be in uncharted territory … and the consequences to the U.S. economy would be highly uncertain and could be quite averse.
Jerome Powell
chair of the U.S. Federal Reserve

The U.S. has never “intentionally” defaulted on its debt, Council of Economic Advisers economists said. This outcome is the one that would cause “irreparable harm,” Treasury Secretary Janet Yellen warned in January.

The precise scope of negative shock waves is unknown since it hasn’t happened before, economists said. But the fallout would likely be serious.

“We need to end this [political] drama as quickly as possible,” Mark Zandi, chief economist at Moody’s Analytics, said of the stalemated negotiations during a Senate Budget Committee hearing Thursday. “If we don’t, we’re going to go into recession.”

That risk comes at a time when the U.S. economy is already bracing for potential recession over the 12 to 18 months, due to its absorption of higher interest rates and a banking crisis that is “still simmering,” Zandi said.

Frozen benefits, a recession, pricier borrowing

The exact date of a U.S. default — known as the “X date” — is difficult to pinpoint due to the volatility of government payments and revenues.

Yellen estimated Monday that the X date could be in early June and possibly as soon as the first day of the month.

Congress can raise or temporarily suspend the debt ceiling in the interim to avert a debt-ceiling crisis — something lawmakers have done many times in the past. But the current political impasse puts their ability, or willingness, to do so into question this time.   

Zandi estimates Congress has until June 8 to avert default.

Justin Paget | Digitalvision | Getty Images

If the U.S. were to default, it would send several negative shock waves through the U.S. and global economies.

A “protracted” default would cause “an immediate, sharp recession on the order of the Great Recession,” the Council of Economic Advisers wrote Wednesday.

That scenario is unlikely, Zandi said. But one that’s short-lived is still expected to do damage, as is a scenario in which the country narrowly avoids default via an eleventh-hour deal.

Here are some of the ways it could affect consumers and investors:

1. Frozen federal benefits

If the federal government doesn’t have enough cash on hand to pay its bills, the most likely scenario is one in which it prioritizes making debt payments to bondholders — meaning other recipients of federal funds would get a late payment, Zandi told CNBC.

That would affect tens of millions of American households, who wouldn’t get certain federal benefits — such as Social Security, Medicare and Medicaid, and federal aid related to nutrition, veterans and housing — on time, the CEA said. Government functions such as national defense may be affected, if the salaries of active-duty military personnel are frozen, for example.

Initially, payments may come a day or so late — but the delay would lengthen the longer a deal isn’t reached, Zandi said.

2. A recession, with job cuts

In that scenario, households would have less cash on hand to pump into the U.S. economy — and a recession “would seem to be inevitable” under these circumstances, Hamrick said.

A default, or even the threat of one, would weigh on financial markets and erode confidence among consumers, investors and businesses, causing a pullback in spending and hiring, Zandi said. And that chaos would impact the U.S. economy.

The U.S. would shed 500,000 jobs and the national unemployment rate would increase by 0.3 percentage point in the third quarter of 2023 if there’s a short default, the CEA estimated. Those numbers balloon in a longer debt crisis — to over 8 million lost jobs and a five-point spike in unemployment.

Even “brinkmanship” may cause 200,000 job cuts, it added.

3. Higher borrowing costs

Investors generally view U.S. Treasury bonds and the U.S. dollar as safe havens. Bondholders are confident the U.S. will give their money back with interest on time.

“It’s sacrosanct in the U.S. financial system that U.S. Treasury debt is risk free,” Zandi said.

If that’s no longer the case, ratings agencies would likely downgrade the country’s top-grade credit rating, and investors will demand much higher interest rates on Treasury bonds to compensate for the additional risk, Zandi said.

Borrowing costs would rise for American consumers, since rates on mortgages, credit cards, auto loans and other types of consumer debt are linked to movements in the U.S. Treasury market. Businesses would also pay higher interest rates on their loans.

4. Extreme stock market volatility

Of course, that’s assuming businesses and consumers could get credit. There might also be a severe financial crisis if the U.S. government is unable to issue additional Treasury bonds, which are an essential component of the financial system, Hamrick said.

“A default would send shock waves through global financial markets and would likely cause credit markets worldwide to freeze up and stock markets to plunge,” the CEA said.

Even the threat of a default during the 2011 debt-ceiling crisis caused Standard & Poor’s (now known as S&P Global Ratings) to downgrade the credit rating of U.S. and generated considerable market gyrations. Mortgage rates rose by 0.7 to 0.8 percentage point for two months, and fell slowly thereafter, the CEA said.

The S&P 500 fell nearly 17% between July 22 and Aug. 8 during the debt-ceiling impasse in 2011, which was “perhaps the closest brush the United States has had” with default, according to a note published by Wells Fargo Economics.

The CEA estimates the stock market would plunge by 45% in the third quarter in a protracted default.

Source: Investing - personal finance - cnbc.com

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