The Debt Ceiling

In January 2023, the United States hit its legal debt limit, risking a government shutdown and provoking a high-stakes political fight over government spending. In December 2012, the United States hit its legal debt limit, risking a government shutdown and provoking a high-stakes political fight over government spending. In November 1995, the United States… well, you get the idea.

The debt ceiling is a legal limit on the amount of money the US government can borrow. But why do we have a debt ceiling, and why do we keep running into it over and over?

I’m Cameron Harwick, professor of economics at SUNY Brockport. Let’s break it down.

The US debt ceiling was first put in place in 1917, right around the time the US entered World War 1. Now World War 1 was an enormous government expenditure by the standards of the time, and the national debt ballooned to eight times what it was before. So why would the US establish a debt limit right at the same time it needs more debt than ever before?

The key to understanding government debt is that you can’t borrow money without credibility. If people don’t think you’re gonna pay them back, they won’t lend you money, or at least they’ll charge you a higher interest rate. And that’s just as true when people lend to the government as it is when the bank lends to you. The debt ceiling was a way for the government to say: hey, I know we need a lot of money now, but we’re gonna make sure we don’t borrow more than we can pay back, so you can trust you’re gonna get more money back.

And sure enough, everyone who lent to the US for World War I got their money back.

Since then, the debt ceiling has been raised 82 times. Which raises two questions: first, what happens if the US reaches the debt ceiling? And second, why have a debt ceiling at all if we can just raise it?

First, if the government ever reaches the debt ceiling, the Treasury isn’t authorized to repay the debt that the the US government owes. In other words, the US defaults. This would be a disaster for government financing, and the government would have to pay dramatically higher interest rates in order to borrow in the future.

So if the debt ceiling is supposed to tie the government’s hands and force it to spend responsibly, why is it looking like the debt ceiling might make the government more likely to default, rather than less?

Think of the debt ceiling like disulfiram, a drug alcoholics use to stop drinking. Of course no drug can physically prevent you from drinking, but it can make very unpleasant if you do, so you commit yourself beforehand by taking it. The debt ceiling is like that. It doesn’t prevent the government from spending money. But it hopefully commits the government to spend responsibly by making it very unpleasant if they don’t.

Of course, disulfiram doesn’t do a lot of good if you can just take an antidote right before you go to the bar. And a debt ceiling doesn’t do a lot of good if Congress can just raise it. In that case there’s no incentive to spend responsibly at all, and any efforts to make the ceiling effective just look like brinksmanship and risking financial disaster for no reason. Just like with other kinds of financial commitments like a fixed exchange rate, while credibility is incredibly valuable, a wishy-washy commitment might be worse than no commitment at all, because it’s more difficult to establish expectations in that environment.

So is the debt ceiling worth keeping? Well, the good news is that, because of the US’ long history of paying its debts and its strong international position, people still think of US government debt as safe. We know this because people are still willing to lend at low interest rates, despite both an enormous and growing debt, and the risk of hitting the debt ceiling. The people putting their money on the line don’t seem to be that worried at the moment. The risk, of course, is that that can change very quickly when new information comes to light. For example if lenders ever do get spooked, the US will have a much harder time regaining its credibility in the future the larger its debt is.

So how imminent is that possibility? Keep an eye on the real interest rate on government debt. For any government – indeed for any borrower at all – that’s the best way to tell how credible the market thinks their promises are.