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Debt Ceiling, U.S. Default, and What’s Next

If you are at all interested in finances, chances are that you are aware of the current debate surrounding the debt ceiling, and the possibility of a default on U.S. sovereign debt obligations. Right now, there is a great deal of wrangling going on, accompanied by partisan grandstanding on all sides. But what does it mean? What is likely to happen if the U.S. defaults? And would it really matter to you?

The U.S. Debt Ceiling

First of all, you need to understand about the U.S. debt ceiling. Article I, Section 8 of the Constitution gives Congress the authority and responsibility to pass laws governing new debt issued by the federal government. Earlier this century, Congress decided that rather than pass a law each time, they’d institute a debt ceiling to help streamline the process. Now, in order to borrow more, a law has to be passed to raise the debt ceiling, rather than on each new debt issuance. In theory, the debt ceiling is supposed to keep spending in check so that it doesn’t exceed revenues by too much, thus maintaining the balance of power. In practice, Congress has raised the debt ceiling as a matter of course for years — no matter which party is “in charge.”

This time, though, it’s different. Some are balking at the idea of enabling the government to borrow money. When the debt ceiling was reached a couple of months ago, some politicians began insisting that they wouldn’t automatically agree to another increase in the debt ceiling. Any law to raise the debt ceiling would have to come with changes to the way the government pays for things. The debate now is over which programs to cut, and by how much. With some noise in there about raising taxes on people and corporations making more than a certain amount of money in order to raise needed revenue.

Could the U.S. Begin Defaulting on Its Debt?

If the debt ceiling isn’t raised by Aug. 2 (earlier since the legislation has to be drafted, reviewed, passed, reconciled, and subsequently signed), according to Treasury Secretary Timothy Geithner, the U.S. begins defaulting on some of its obligations. There are Social Security checks that need to go out. Government employees need to be paid. We have other obligations, such as paying interest on Treasury bonds. While everything wouldn’t be defaulted on all at once, certain obligations would need to be met.

In an interview with CBS Moneywatch [3], Jay Powell, a visiting scholar at the Bipartisan Policy Center, estimated that the U.S. could default on 44% of its obligations in the month of August. He says that interest would be paid (most countries don’t just declare bankruptcy and walk away from their debts), and then priorities to keep certain programs, like Defense, going would be set. But there would likely be some disruption.

And, of course, there would be disruption in the financial markets with a U.S. debt default. Stock portfolios (your retirement account, perhaps) would sink as the market crashed. Reluctance to invest in Treasury bonds [4] would result in higher yields to try and entice foreign investors. That, in turn, would mean higher mortgage rates, and higher loan rates for businesses. A credit market crunch would be likely, and that could hurt business cash flow, resulting in lay offs.

Will the U.S. Reform It’s Financial Practices?

One thing this crisis has done is to wake many up to the unsustainable financial practices that the U.S. has been following. How to get the country back on the right financial track is a matter of debate. Some think that the problems can be resolved with tax increases, or with spending cuts [5]. Few politicians suggest that we will need both spending cuts and tax increases to get out of this problem. (I, personally, believe that program cuts and a tax hike will be necessary.)

The real question, of course, is whether the American people are willing to sacrifice to get out of this mess. And whether we have an political leaders with the courage to do something unpopular. What do you think? What should we, as a country, do about the debt ceiling, and about fixing our country’s financial woes?

(Photo: MyEyeSees [6])