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What is Debt Ceiling? Overview and How it Works

August 25, 2022 by victory Leave a Comment

What is debt ceiling? Overview and how it works

The debt ceiling discussion is an endless one amongst economists and politicians, and who can blame them. The concept indeed warrants an in-depth knowledgeable discussion. 

If you live in a country where credit is easily gotten like the United States, then you would understand the importance of a debt ceiling by default. This is easily noticed if you’ve had to borrow money. 

Everyone has a debt ceiling, but where this debt ceiling is and the structure around it is what differs. Some have a debt ceiling of $1000, some $1 million and some companies have in hundreds of millions or billions if their creditors will allow. 

Not only do individuals and organizations have debt ceilings, but governments also do too most especially the United States government. Let it not surprise you when you find out how much debt your government carries. 

This article discusses the debt ceiling concept, the possibilities around it, its impact, and all other important details. 

Introduction 

The United States Federal Reserve, in its report on the economic well-being of U.S. Households in 2020, analyzed banking and access to banking and credit services for U.S. households and also addressed those it referred to as the unbanked and the underbanked. 

While it is easy to throw the spanner of negativity into the works of credit services, it is also important to state the frustration of those who cannot access credit. This may be due to situations that have kept them unbanked or underbanked. 

The United States Federal Reserve’s report states that access to banking and credit services from traditional financial service providers, like banks and credit unions, can be important for people’s financial well-being. 

In 2020, the majority of adults had a bank account. Also, that they were able to receive credit from conventional sources. However, the minorities and those with low income still face significant barriers to basic financial services. 

Borrowers with credit cards reduced their outstanding balances in 2020. Also, fewer adults used their cards to carry sums from month to month.  

In addition, the percentage of people seeking credit has decreased, as has the percentage of adults using alternative financial services. Credit card balances grew among persons who were laid off in the previous year, despite the overall reduction in credit card borrowing. 

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What is a debt ceiling? 

Since 1917, the “debt ceiling” has been the statutory monetary limit imposed by the United States Congress on the amount of money the Federal Government is permitted to borrow (usually via the Treasury selling Treasury Bonds and Notes), i.e. the total, legally permissible U.S. Public Debt.  

It is similar to a credit card’s “credit limit”. Only the nominal limit is determined by the borrower (Congress) rather than the lender (buyers of treasury securities). 

The debt ceiling is a politically controversial topic for some reasons; 

  • When the federal government borrows money, it does so because it cannot fund all of the spending prescribed by Congress (under the statute known as the United States Federal Budget). This is not a viable means of running a government on a long-term basis.
  • The public debt of the United States is presently nearly 100% of GDP, or $20,940,000,000,000.00 ($20.94 trillion dollars). This is the same as having all of your personal debt equal to your annual income.
  • Without respect to tax rates, the federal government has only been able to collect up to 20% of GDP in tax revenues during the previous 60 years. This observed tax revenue ceiling establishes a ceiling for total, sustainable federal expenditure, including the maximum debt service (interest payments on the public debt) that the federal government can really make, i.e. the maximum sustainable US Federal Budget.
  • While Congress sets the nominal, legal public debt ceiling, there is another, unspoken limit: the number of money lenders are willing to lend to the federal government. No one will show up for the weekly Treasury securities auction at some time. As the bid prices of such bonds fall and their yields (effective interest rate) rise, we will see signs that we are approaching this limit. 
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Raising the debt ceiling 

Because the debt requirements expanded quicker during WWI as a result of wartime spending, Congress enabled the Treasurer to issue bonds without previous Congressional permission for each bond issuance — subject to a total debt limit, or the debt ceiling.  

To borrow more than the ceiling allows, the Treasurer must seek Congress to raise it. Thereby giving Congress another chance to chastise the Administration for its fiscal recklessness. 

When Congress doesn’t want to criticize the president, they raise the debt ceiling as part of appropriations legislation that necessitates deficit spending, and no one notices.  

The Treasury is always selling bonds and bills to raise enough cash to satisfy spending obligations since we have been operating on a deficit budget for many years.  

If the Treasury borrows until it is close to the limit established by Congress, it must request an increase from Congress, which has never been granted.  

Some parts of the government may be shut down due to a lack of running funding if some members of Congress, usually Republicans, play hardball. 

It’s similar to having a credit card that lets you charge on it and go over your credit limit without the business bothering you.  

What if the credit card company now informs the merchants from whom you purchased that “we have chosen not to expand this person’s credit limit, hence we will not pay you for these charges”? That is exactly what not increasing the US debt ceiling entails. 

See Also: Is it Better to Save or Pay Off Debt? in 2022

Recognizing a debt ceiling 

Assume you own a credit card. And this credit card, say, has a $5000 limit. This credit card is nearly maxed up (which you should ask yourself some questions about), and you don’t have much cash on hand. 

You need to buy some things today and have no alternative but to use your credit card to do so. After you’ve purchased everything, your credit card is entirely depleted. 

Your debt ceiling is this credit card. And at this moment, your credit limit has been reached. 

Now let’s think of something further. You know you have certain expenses to pay next month. Also, you know you have some money coming in (from a paycheck or any other source of income). 

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The problem that pops up then is that when you compare what you have come into what you have to pay, you realize you don’t have enough. Let’s pretend you know you’ll be $500 short.  

So now you know you’ll be short. Also, that you just have one genuine option: phone your credit card provider and request a limit increase. This way you lift your debt ceiling even higher. 

Lifting your debt ceiling may be possible for you to do. This may be controversial in some way, but isn’t for many people in most parts of America and the rest of the world. 

The banked, the unbanked, and the underbanked 

The Federal Reserve Bank’s report further stated that the majority of persons in the United States (81%) were “completely banked,” meaning they had a bank account and had not used any of the alternative financial services mentioned in the study in the previous 12 months.  

Money orders, check cashing services, payday loans or payday advances, pawnshop loans, auto title loans, or tax refund advances are examples of such services. 

A further 13% of those surveyed had bank accounts but used alternative financial services. These adults are classified as “underbanked” because the banking services they had access to did not appear to be adequate to address their financial needs. 

The remaining adult population (5%), on the other hand, did not have a bank account. Alternative financial services were used by less than half of these “unbanked” persons. 

The problem with underbanking and patronizing alternative financial services is that the costs are higher than they look. A Forbes article on the costs of being underbanked addresses this.  

While the upfront costs of alternative financial services may appear to be more appealing, they add up to a significantly higher cost over time.  

According to the Financial Health Network, in 2018, the most recent year for which complete data is available, unbanked and underbanked Americans spent $189 billion on fees and interest on financial products.  

Using the FDIC’s estimate of 63 million unbanked or underbanked Americans, that equates to an annual cost of $3,000 per person. 

These are merely the direct costs that unbanked and underbanked households face, no matter how large they are. There are also indirect expenses that can have even more serious ramifications. 

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How does a lack of access to credit affect the debt ceiling? 

The fact that is that a lack of access to credit limits you as your debt ceiling is just above your head or probably even lower. It can be so much pressure that it places a huge load on the individual who would have preferred to access credit instead. 

Unbanked people frequently utilize prepaid cards to conduct transactions that a bank customer would conduct with a credit card.  

Although prepaid cards cover a critical void for the unbanked, they frequently come with additional costs. An activation charge, a monthly fee, and costs for making deposits or using the card at an ATM may be required. 

The most significant disadvantage of utilizing prepaid cards is that, unlike credit cards, they do nothing to assist users in establishing and maintaining a credit history. Unbanked and underbanked people will be unable to obtain loans unless they have a credit history. 

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Without a credit history, employers, landlords, utility companies, and insurers can use it to decide who to hire, rent to, offer service to without a deposit, and insure. 

As of 2020, the median amount borrowed through a payday loan is $375, according to Microcredit Summit, an organization dedicated to lifting American families out of poverty.  

One of the major advantages of having an emergency fund is that you may avoid the excessive fees and interest rates of a payday loan. For the unbanked and underbanked, however, even $375 in savings might be difficult to accumulate. 

See Also: 15 Best Ways To Get Out Of Debt | How To Be Debt Free

Notable example of a debt ceiling crisis 

A debt ceiling crisis occurs when there is no debt ceiling raise or when the creditors refuse to raise the debt ceiling. A notable example of a debt ceiling crisis is the Greek debt crisis. This is because most people can remember how terrible that day was. 

Greece’s fiscal deficit topped 15% of its gross domestic product in 2009. 2 Fear of default exacerbated the 10-year bond spread, eventually causing Greece’s bond market to collapse. This would put a stop to Greece’s capacity to repay its debts in the future. 

A widespread default in Greece would have a more immediate impact. First, without financing from the European Central Bank, Greek banks would have gone insolvent.  

Other European banks’ solvency would have been jeopardized as a result of the losses, notably in Germany and France. They held 34.1 billion euros in Greek debt, along with other private investors. 

The same thing was observed in Europe and work to prevent it from becoming a crisis is already on. This one was called the Eurozone crisis.  

The Eurozone Crisis began in 2009 when investors were concerned about rising government debt levels in numerous European Union countries. Sovereign bond rates rose as they began to allocate a larger risk premium to the area, putting pressure on national budgets. 

Regulators saw these patterns and promptly put in place a 750 billion euro bailout plan. However, the crisis remained, owing in part to political differences and a lack of a unified approach among member states to handle the matter in a more long-term manner. 

Conclusion 

The debt ceiling is a mechanism that forces Congress to acknowledge that there is a limit to our ability to borrow and to carefully consider the dire consequences of borrowing too much, i.e. reaching the real debt ceiling.  

This is the point at which no one will lend to the federal government. One such example is the Greek debt crisis, which resulted in the country’s economic ruination. 

References 

  • cnbc.com/
  • federalreserve.gov/
  • thepeacepine.com/
  • lawinsider.com/
  • forbes.com/
  • data.worldbank.org
  • en.wikipedia.org/
  • thebalance.com/

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