Debt Ceiling: What It Is and What's Next

Lawmakers voted on October 7 to temporarily raise the U.S. debt limit, averting a default that some experts say would have been devastating to the American economy. It's been hard to avoid talk of the U.S. debt ceiling recently, especially when it's come alongside hefty terms like historic, turmoil and yes, even recession. But what does it all mean and what happens next? RBC Global Asset Management (GAM) explains.

The following insights are from Krystyne Manzer, Vice President, Portfolio Specialist, RBC Global Asset Management, in a report originally published on October 6 titled "Understanding the debt ceiling."

In late September 2021, U.S. Treasury Secretary Janet Yellen announced that the U.S. would run out of extraordinary measures to keep the government funded if the debt ceiling was not raised by October 18th. Congress then reached an agreement that will raise the ceiling until December 3. This temporary fix brought relief to markets. However, the clock is ticking and the ceiling will still need to be suspended or raised again by the new deadline.

Note that we think it's very unlikely the debt ceiling will not be raised in time. First, this would lead the U.S. to default on its debt. Second, the Democratic Party controls the White House and has a majority in both levels of Congress. This means it has the capacity to increase the debt ceiling without the support of the Republican Party if necessary.

Negotiations will continue to take centre stage as December approaches. While the situation is likely to evolve, the points below will provide some context.

What is the debt ceiling?

The debt ceiling is a limit Congress sets on the total amount of debt the U.S. government can have outstanding. This includes any debt held by the public as well as that issued for government accounts like Social Security and Medicare. The limit is now set at $28.88 trillion, an increase of $440 million under the recent agreement.

Why does it need to be raised?

The U.S. typically operates at a fiscal deficit. In other words, it spends more dollars than it receives in the form of taxes and other revenues. The government has payments that it is contractually obligated to make, including interest payments on existing debt, contributions to social programs, military spending, and other previously approved spending programs. When government coffers are near empty, the government borrows by issuing more Treasury bills (T-bills). If the government is already at the legal limit of outstanding debt, the debt ceiling needs to be increased to allow for more borrowing. Failure to do so would lead the U.S. to a technical default on its debt.

Note that the debt ceiling isn't raised to allow the government to fund net new spending measures. The spending programs have already been approved by Congress. The new T-bills are intended to fund these programs. In essence, it's the credit card bill that arrives in January after the holiday spending has already occurred and gifts have been distributed.

Why does the debt ceiling exist?

The original goal behind the debt ceiling was twofold: to make it easier for the government to finance the costs of World War I (WWI) while addressing the concerns of those who feared spending would subsequently spiral. Previously Congress reviewed and approved each individual debt issuance. In the post-WWII period, this changed to a more general limit.

Why does this seem to be an issue every few years?

Because of the fiscal deficits mentioned above, debt levels continue to grow. The ceiling has been raised nearly 100 times since WWII, though in recent years there has been more of a bias towards suspending the ceiling rather than raising it to an arbitrary new level. Suspending the ceiling means the government can continue borrowing more for a certain period of time. These suspensions typically last for only one to two years. At that point, new resolutions need to be passed to either raise the debt ceiling or extend the suspension.

Magnifying the issue in 2021 are the huge stimulus and spending programs introduced in the wake of the pandemic.

What happens if the debt ceiling isn't raised?

Once the debt ceiling is reached, the U.S. Treasury isn't able to issue new bonds to finance approved spending measures. After that point, they can make use of extraordinary measures to keep the country out of technical default, halting reinvestments in government retirement funds. For example, the U.S. could scramble to find other sources of funds by borrowing from other government agencies or selling assets. But doing so could undermine confidence in the U.S. government.

If the extraordinary measures run out before there is a new agreement in place, the Treasury will need to make some decisions around which bills to pay to avoid defaulting. This would put significant pressure on politicians, though it's unlikely to come to this given that the Democrats control all three levels of legislature.

Instead, it's likely the Democrats will pass a reconciliation for the debt ceiling that is not tied to their larger spending bill. This therefore won't require bi-partisan approval and can be easily passed within the party. The chance of an outright default is extremely low.

What would a default look like?

If the U.S. were to actually default on their debt, the country's sovereign rating would be downgraded. Bondholders expecting interest or principal repayments wouldn't receive them. This would see yields increase in the bond market, also increasing borrowing costs for households and businesses.

Perhaps more importantly, the country's reputation would be severely damaged. Outflows would likely result, which would be very costly to the global economy and markets. The U.S. dollar would fall. The money market would be damaged, and so would the repurchase (repo) market.

That said, a default situation would be temporary. Congress would be pressured to make a deal so the U.S. could start paying its debt and borrowing again shortly thereafter.

Why not permanently remove the debt ceiling?

In theory, this would certainly remove some of the inefficiencies caused by seemingly having to debate pre-approved spending programs a second time around. Yet there are two major concerns:

1. Would this remove the limits on the government – almost like a free pass to spend without consequence? Of course, practically speaking, there would be limitations, not the least of which is the need to have any new spending measures pass through all three levels of legislature.

2. What are the consequences of high public debt levels? Right now, the cost of servicing existing debt is extremely low. Interest rates are expected to remain fairly low due to a number of long-term headwinds. However, it's possible that high debt levels will become more of a global focus at some point in the future.

How might we see this play out?

The next few weeks might be somewhat tumultuous from a headline perspective. But it's extremely likely that the debt ceiling will once again either be raised or suspended before the December 3 deadline. So far, the market has shown some small signs of concern, but has not priced a significant risk of default into Treasuries. While markets may experience some additional volatility if the day draws near without a resolution, we expect it to be temporary in nature.