The ABC of US Debt Ceiling Crisis 2011

Balki Bartokomous once said “I am in Debt. I am a True American”. How true, isn’t it? And by the law of association, the American Government is the world’s largest debtor. Just look at the ongoing US Financial Debt Ceiling Drama – 2011 which concluded on August 2, 2011 (at least for the time being) after the US Senate finally agreed to increase the American Debt Ceiling limits to prevent the American Government from defaulting on its financial obligations.

So what is this US Debt Ceiling Crisis all about? Here is a brief presentation in simple English of the entire issue.

What is Debt?

Debt is the financial obligation (meaning money or any valuable goods) that one party (the debtor) owes to the other party (the creditor). The most common form of debt is a loan. Suppose a Person A takes an amount X from another Person B, and agrees to pay back the amount X with an interest of amount Y after a period T. In this case the person A is the debtor. He owes a debt of amount X+Y (principal+interest) to the person B at the end of the loan period T.

Now this is the simplest form of debt where one person owes another person some money he borrowed earlier and any additional interest on the sum borrowed. But payments can also be made in the form of other goods or services in return for the borrowed amount, if both the debtor and creditor have agreed on the mode of payment.

What are US Treasury Bills and Bonds?

Just like a household has to manage its monthly expenses by having a fine balance between income+loans on one side and expenses on the other side, national governments have to manage their expenses too. The income of governments are usually in the form of taxes, fines, etc. But for most governments this revenue is insufficient to manage their financial commitments. Government is not a business enterprise, is society oriented and hence will have spending related to social programs, subsidies, spending related to political compulsions, spending on various small and big time projects, defense expenses, health care and education, and so on. And finally to a large extent there will be spending related to fund mismanagement and wrong economic policies.

So usually for a government, its revenues  alone are not enough to fund its expenses. So governments take loan too. So this becomes government debt or the national debt – the debt which the government owns internally (to its own people, banks etc) or externally (to other countries, banks, etc).

US dollar is the most widely accepted currency in the world. To know why, Read – What makes US dollar the most Powerful Currency? – A Trillion Dollar Secret. US Government at the same time has the largest expenses in the world – a lot of which goes to constantly fund the military expenses of US defense forces deployed worldwide. If the US treasury cannot fund its expenses merely by using its revenue, then it has no other way but to borrow from internal and external sources to meet its expenses.

To fund its expenses by borrowing from creditors, the US treasury issues Treasury bonds, Treasury Notes, Treasury Bills etc. In simple terms what this means is that – you can for instance buy a Treasury Note of 1000 US dollars from the US government say for a period of five years at an interest of 3% per annum. You can even get some discount while buying it, say 50 dollars. So you pay 950 dollars to the government, get a 1000 dollar Treasury Note in return, and once in every six months you will receive the interest, and at the end of five years you will get back the original sum of 1000 dollars.

This is like depositing your money with the government (or say providing a loan to the government) at a fixed interest rate. The US treasury bills, notes, bonds etc vary in the maturity duration. Treasury bills usually mature within a year, Treasury notes mature between one to ten years, Treasury Bonds have longer term of maturity like twenty to thirty years and are usually purchased by foreign countries or large corporations.

Having said that, investment in US treasury is considered to be one of the safest investments in the world because of the international acceptance of US dollar. Currency is after all paper money and has value only when there is a wider acceptance to it. You cannot take the currency of some poor African nation and except it to be accepted in some European country. On the other hand, the US dollar is accepted worldwide.

So foreign governments who have excess money to invest usually find investing in US security bonds to be the safest form of investment. This is based on two strong assumptions that

  1. The American government will not default on its loans and will always pay back the sum assured.
  2. The US dollar will continue to be an universally accepted currency.

If either of these assumptions go for a toss, then the market will lose its faith in US treasury issued security bonds. Also read Facts behind the Paper Currency – I Promise to Pay the Bearer

Debt Ceiling Information Campaign - http://www.flickr.com/photos/publicnoticemeida/5911890363/

What is US Debt Ceiling?

So now we know how the US government funds its additional expenses every year. It just issues more and more Treasury Notes, Bonds, Bills etc. US citizens, banks, companies, foreign nations all buy those bonds and invest their money to fund the US government expenses. In return for their investment, they are assured of security and interest payments in US dollars, and the promise of getting back their invested money once their bonds reach their maturity term.

But how does the US government pay back the principal amount when the bonds mature over a period of time? The government’s expenses also are ever increasing, right? The puzzle is solved by issuing more and more bonds every year :)

So its like, I take 100 dollars of loan this year to fund my expenses outside my revenue, and promise to pay back 110 dollars next year to the creditor. Then next year, I take 300 dollars of loan, pay back the 110 dollars, and use the remaining amount to fund my additional expenses in the second year which are beyond my revenue that year. Then in the third year, I take 500 dollars of loan, payback 330 dollars of existing loan in that, and use the remaining amount to fund my additional expenses in the third year. And this cycle goes on and on. Who is going to stop me from taking more loan as long as people know that I am going to pay back their loan with interest on time without fail?

This is what all the governments worldwide who spend more than what they earn do every year. They simply continue to borrow more and more and fund their ever increasing expenses. But lo, not all government will be able to find creditors (or say investors in their bonds), because investors dont believe in the financial health of all governments. Most governments will find investors in their bonds only within their country, because they promise their countrymen to payback their investments, and usually within a country the safest investment would be investing in their government, because unlike private enterprises, governments rarely default.

But when it comes to international investments, like one government investing in the other government, credibility matters a lot. Hence, the most preferred investment is investing in US treasury bonds, which are assumed to be the safest. And the US government has been using this financial trust to fund its ever increasing budget deficit, and has been able to fund its great spending on scientific research, space programmes, providing aid to other countries, funding its huge military expenses, investing on mega projects and so on.

At the same time, UNLIKE any other country, the US government has a self imposed limit on how much money it can borrow every year to fund its additional expenses in the budget which are beyond its current income. Now what this means is that there is a maximum limit pre-approved by the US Congress, and the amount of debt the US government borrows should never cross this pre-approved limit.

If the government wants to borrow beyond the currently approved limit, then both the houses of the US congress have to vote and approve that increase in the government’s borrowing limit. Then this has to be finally approved by the US President after which it becomes a law. Without this approval the US treasury will have no rights to borrow additional funds (by issuing additional treasury bonds etc). The US treasury simply cannot borrow more than the statutory limit approved by the US Congress, even if it means that the government will undergo a financial default and will fail to meet its financial obligations and will have to start closing down government operations.

So every time the US government is about to exceed its current borrowing limit and requires additional funds to manage its expenses, the US congress has to decide on a new limit and approve that limit. This limit up to which the US government can borrow money is called US Debt Ceiling. The 2011 US Debt Ceiling Crisis started when the US Congress initially REFUSED to raise this limit any further, which meant that the US government had to default on its commitments because the available funds with the US government were simply not enough to pay back the interests, pay back the matured bonds, to fund the government expenses, etc. So if the debt ceiling was not raised, then the US government will have to make massive cuts in its spending, and then also decide whether to honor its internal commitments like paying salaries, funding research, healthcare etc or to default on its promises of paying interests and maturity amount to its creditors.

US Debt Ceiling Crisis 2011

Before we going into the details of the 2011 US Debt Ceiling Crisis, let me reiterate that US is only one of the two countries in the world which have a debt ceiling – a limit on how much the government can borrow. The only other country in the world which has this limit is Denmark, and its debt ceiling is so huge that it will probably never reach that limit. So the Debt Ceiling Crisis is not as if US government is going to go bankrupt all of a sudden because of some grave financial crisis, it is only that it faced a possibility of default because the US government was not allowed by its own law to borrow more funds.

If all the governments world wide had a similar debt ceiling, then most governments would have a debt ceiling crisis almost every year, some almost every week. Most governments where there was a strong opposition party in power would almost default every time. Think about a debt ceiling in India, and what would happen if the government reached its debt ceiling today? The government itself is an alliance of n-parties who are every now and then trying to pull each other. This combined with the strong opposition numbers in the parliament, a situation requiring a rise in the debt ceiling would cause stock markets to crumble every minute.

So governments like India don’t face the debt ceiling crisis simply because we dont have any limit on how much our governments can borrow, nor do we ever think who, how and when are we going to pay back those debts. Not that the ones with a debt ceiling think about repayment, but they at least have a maximum limit on how much they can borrow, and then there is somebody to question, debate and approve it.

But again, one can borrow only if there is somebody to lend. This has never been an issue to the US government because of the powerful US dollar. There always will be those willing to lend to the US government. However that is not the case with say India. Just because Indian government is willing to borrow does not mean that there will be always creditors waiting to lend. There is also something called credibility and trust. Given the fact that India is the world’s fourth largest economy today, credibility may not be an issue (provided you ignore the multi-crore mega corruption scams in recent times).

Remember in 1990s India didn’t have enough money even to buy Petroleum for the next few days! Nobody was willing to lend to India because of a lack of credibility and economic instability in the country. The earlier government under Rajiv Gandhi had borrowed loans at very high interest rates further weakening the financial position of the government. India had no other option but to liberalize its market if more money were to flow in and if international banks were to offer loan. India had to devalue its currency, the India Rupee – twice within a span of few days so that we could start exporting our services and make profit.

So it is not like it was a deliberately planned liberalization programme to boost the economy that Mr. Manmohan Singh undertook with the full support of the then Prime Minister Mr. P V Narasimha Rao. Instead it was a desperate situation into which the country was pushed into –  where the government was about to default on its commitments because of lack of funds to run the state. P V Narasimha Rao provided the required shield to Manmohan Singh so that he can start the much pending liberalization process without any internal pressure.

History of US Debt Ceiling Limit

From the very early days of its independence, the US Parliament (ie US Congress) has had a control over the borrowing limit of the US government. Till 1917 the US Congress used to approve each borrowing by the government on an individual basis, which is a sign of a very healthy economic governance. As the expenses of World War I sky rocketed, there were multiple borrowings made by the US government, and so the US Congress introduced a limit on the borrowing power of the US government which is the US Debt Ceiling limit. And since then, the US government had no need to get the approval of the Congress on a case by case basis for each borrowing. Instead it just had to ensure that the sum total of all its borrowings remained below the latest approved Debt Ceiling Limit. The Congress continue to increase the Debt Ceiling limit frequently after that whenever there was a need to borrow more than allowed by the current limit.

So till recently the increasing of US government debt ceiling limit was considered to be a mere formality, because most of the times, the political party to which the US President belonged to was also the Party which enjoyed a majority in the US Congress. Hence the government normally had no difficulty in getting the debt ceiling limit increase approved by the US Congress.

But unfortunately for President Obama there were multiple problems to address.

  • The costs of the wars being fought at Iraq and Afghanistan were already sky rocketing when he assumed power. This meant a massive increase was required in the existing debt ceiling limit.
  • President Obama’s Democratic Party did not have the required numbers in the US Congress to get the bill raising the debt ceiling limit passed. Obama had to depend on the votes of the Republican Party as well to ensure that the bill approving the new limit was passed without any issue.
  • The ongoing Economic recession due to the Subprime Mortgage Crisis further increased the financial burden on the US government. There is an increasing pressure on the government to create more jobs in US.
  • The earlier Bush era had largely reduced taxes and that policy was continued by Obama’s government to a large extent.

NOTE: US also has a largely unsustainable trade deficit, where in its imports hugely exceed its exports which is not the sign of a healthy economy. US has to simply keep printing more dollars and hope that it will continue to be accepted worldwide. And in doing so also has to ensure the dominance of US dollar. If it not were for the worldwide acceptance of the US dollar, the US economy would have collapsed long back, because you can’t simply keep buying (spending) more and more and more compared to what you sell (or earn).

Just take a look at the last few major increases in US debt ceiling limits. Earlier it used to be billions of dollars, not it has reached trillions!

  • July, 2008 – The debt ceiling limit was increased by $800 billion increasing the total limit to $10.615 trillion.
  • October, 2008 - The debt ceiling limit was increased by another $700 billion.
  • February 2009 – The debt ceiling limit was increased by another $789 billion to $12.104 trillion!
  • February 2010 –  The debt ceiling limit was increased by another $1.9 trillion to $14.294 trillion!

Clearly this is completely unsustainable. You simply cannot keep borrowing forever and ever and more and more without any clear economic policies to contain the situation. And hence the Debt Ceiling Crisis 2011.

According to the Congressional Budget Office, President Obama’s proposed FY 2012 budget will add another $9 trillion to the publicly held debt over ten years. Under the President’s budget and the House passed budget resolution, the debt limit would need to be raised to fund the government through the end of FY 2012. Beyond then, things will get even worse as the retirement of the baby boom generation hits full stride. - Source: Understanding the Federal Debt Limit

Just to give one a picture about the current US debt – in India the national debt per person is around 30,000 rupees per head today, while in the US the national debt per person is nearly 45,000 dollars per person! Considering the difference between the purchasing power of Indian rupees and US dollar, the US debt is a substantially larger one.

As a matter of fact, in December 2009, the US debt crossed the statutory limit set by the US Congress. While the debt ceiling then was $12.104 trillion, the treasury department posted the national debt at nearly $12.135 trillion! The explanation from the US treasury department about the national debt crossing the maximum limit set was that it had “extraordinary accounting tools” at its disposal which it can use to increase the debt upto $150 billion above the maximum limit set by the Congress. Now I have absolutely no idea what on earth does this “extraordinary accounting tools” mean, because my knowledge of economics says that money can be legally earned only by borrowing it or earning it, not by using any tool. If this tool is the third way to earn money legally, then I would love to have that tool too :)

To contain the ever increasing government debt, Obama and his Democratic party wanted to increase the taxes on the people. On the other hand, the opposition Republicans were opposed to any kind of increase in the taxes and instead wanted the government to massively cut down on its unnecessary spending. Added to this was the fact that the tax-cut programme started by the earlier president George Bush was continued by Obama and this in itself was causing the US government more than a trillion dollars over a period of 10 years! Way back in 2001, the Democrat Tom Daschle had opposed the massive tax cut saying “I just know that at some point that reality is going to come crashing down on all of us and we’re going to have to deal with it“.

If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours. - John Maynard Keynes

Now this is exactly the situation into which China ran into during this US Debt Ceiling Limit crisis. China is the largest external holder of US treasury bonds amounting to over a trillion US dollars, and if the US government defaults on its debts then China will be the biggest sufferer with all the bonds it holds being reduced to mere paper. China anxiously watched as US debated over raising the ceiling limit.

“Of course we are concerned about the safety of our assets. To be honest, I’m a little bit worried. I would like to call on the United States to honor its words, stay a credible nation and ensure the safety of Chinese assets” – Chinese premier, Wen Jiabao

China is the largest single holder of US government debt amounting to around 26% of foreign owned US government debt. However, contrary to the popular belief, only 32% of total US debt is owned by foreigners, the remaining US debt is owned within the US itself by US companies, banks and its citizens.

Major events in US Debt Ceiling Limit Crisis of 2011

  • On January 6, April 4 and May 2, 2011 – The US Treasury department sends three letters requesting an increase in the current US debt ceiling, so as to enable the treasury to continue issuing treasury holdings for creditors to buy.
  • January 28, 2011 – Moody’s investor service says that it may place the AAA rating of US debt on a “negative” outlook – which would affect the so far strong credit worthiness of the US government debts.
  • April 18, 2011 – Another credit rating agency, Standard and Poor’s revised its outlook on US to “negative”.
  • May 16, 2011 – The current debt ceiling limit is reached and US treasury enters a Debt Issuance Suspension Period – US treasury stops borrowing money.
  • May 25, 2011 – The US Senate rejects Obama’s budget proposal by a vote of 97-0
  • May 31, 2011 – The US House of Representatives rejects a bill to raise the Debt Ceiling Limit by $2.4 trillion with 97 votes favoring it and 318 opposing the bill.
  • July 19, 2011 – The US House of Representatives votes for a bill brought in by the opposition Republican party, which allows the Debt Ceiling Limit to be increased by $2.4 trillion subject to the Cut, Cap and Balance Act condition that the current spending by the government be Cut, the future spending be Capped, and the constitution be amended to take away the power of increasing the US debt ceiling limit beyond the earning ability of the US government.
  • July 22, 2011 – The Cut, Cap and Balance Act bill failed in Senate. Senate Majority Leader Harry Reid called the Act “one of the worst pieces of legislation to ever be placed on the floor of the United States Senate“. Even if this bill had been passed by the US Senate, President Obama had promised to use his power and veto the bill, preventing it from becoming a law. Obviously no government would like to have a cap on the ability to increase its borrowing limit? :)
    NOTE: Perhaps, Germany is an exception which has enacted a law in 2009 which states that starting from 2016, the German Government cannot borrow above 0.35% of its GDP, unless under emergency circumstances.
  • July 25, 2011 – Obama and Speaker of the House John Boehner addressed the nation separately over television with regards to the debt ceiling crisis.
  • July 30, 2011 – The House of Representatives rejects Senate Majority Leader Harry Reid’s proposal of $2.4 trillion to reduce the deficit and raise the debt ceiling.
  • July 31, 2011 – President Obama announces that leaders of both parties have finally reached an agreement to lift the debt ceiling.
  • August 1, 2011 - The House of Representatives passes the bill approving the increase in US debt ceiling limit.
  • August 2, 2011 - The US Senate passes the bill approving the increase in US debt ceiling limit, and Obama approves the bill making it a law on the same day.

The Agreement to end the 2011 Debt Ceiling Limit Crisis

The agreement reached between the two parties was that,

The deal would raise the debt ceiling by $2.4 trillion in two stages, and provide initially for $917 billion in spending cuts over 10 years. A special committee of lawmakers would be charged with finding another $1.5 trillion in deficit reduction, which could come through a tax overhaul and changes to safety-net programs. – Obama & Congress Reach Debt Deal – The Wall Street Journal

In simple terms what the deal means is that, while approving the increase in Debt Ceiling Limit, the deal also imposes spending caps on the US government for the next 10 years. Now where exactly the US government would cut its spending on is left to be decided by different committees which are to be setup by the US Congress. Most democrats from the President Obama’s Party are angry because they feel that the Republicans were finally able to impose spending cuts on the government.

The cuts in government spending would mean that the US military activities around the world would be impacted. Of the $1.2 trillion agreed cuts in government spending, half of the amount would be cuts in defense spending. Looks like there will be massive troop withdrawals from Afghanistan and Pakistan in the near future.

Finally, with all these debates, and discussions, and settlements – the predictions are that the current debt ceiling limit will enable US government to fund its expenses only till the end of 2012. What happens after that? Hope, the Doomsday said to be predicted in the Mayan Calendar on December 21, 2012 is not an Economic Doomsday :)

References:

  • Raj Singh

    So in the coming years, even if US continues to borrow more and raise the borrowing limit, there is simply not enough dollars to lend it to US, so US will have to print more and more dollars to fund its economy, and that means a depreciation in the value of dollar.

    Above statement of your’s is it because by printing more inflation will be more.

    Secondly explain me “”even if US continues to borrow more and raise the borrowing limit, there is simply not enough dollars to lend it to US”" ..

  • Prashanth

    Interesting piece of writing.I don’t know much about economics but I think most of the problems are because of different currencies.I would have liked gold coin as the universal currency across all nations, as it was in Vedic times.So these problems of rigging up exchange rates,printing currency notes indiscriminately won’t exist.There might be a downside to it especially in a recession, but benefits are far more I think.

  • Prashanth

    Interesting piece of writing.I don’t know much about economics but I think most of the problems are because of different currencies.I would have liked gold coin as the universal currency across all nations, as it was in Vedic times.So these problems of rigging up exchange rates,printing currency notes indiscriminately won’t exist.There might be a downside to it especially in a recession, but benefits are far more I think.

    • Anonymous

      You are right Prashanth, the very existence of currencies came from the valuable gold coins in the past. See - http://www.hitxp.com/articles/economics/promise-pay-bearer-currency-history-federal-bank/

      Valuables should be priced by valuables. Paper currencies are only playing with numbers. If you take Indian currency notes and go to some country in Africa or vice versa, then these notes have absolutely no value. Recessions simply prove that the current economic models are inherently unsustainable after a given time. As simple as that.

  • Preejoshi

    excellent explanation.

    • Anonymous

      Thanks Preeejoshi

  • Sriprabhanjan

    excellent information and analysis in simple words…..gud work ….thanx a ton

    • Anonymous

      You are welcome Sriprabhanjan :)

  • raj b

    thanxx a lot!!

    • Anonymous

      Welcome raj :)

  • Bthilak

    Hi Guru, I am avid fan of your articles. I have read and admired many of your articles, including this one.

    Regarding the US debt ceiling, I understand the necessity of borrowing limit and the debt. But cutting the government expenditure also would reduce money circulation, eventually causing the economy to be affected.
    Your views please

    • Anonymous

      Yes Bthilak, US has over spent much more than its earnings and this cannot continue forever. It has to cut on its spendings and that means a slowdown again, because all these years for the past 2-3 decades the entire world economic equation has been asia produced and US consumes – all asian countries including India devalued their currencies against dollar so that they can export cheap services and goods to USA  - this is not a sustainable model. Too much of consumption on one side and too much of savings on the other side – China has over a trillion dollar in reserves, Japan has over 900 billion dollars and so on – and now if the value of dollar comes down in the global market because of an US credit rating downgrade – the dollar surplus of debt owning nations like China, Japan all would have its value reduced too – for a slowdown in US means less demand for dollar and less demand for dollar means further reduction in dollar’s value. 

      China understands the futility of this model and has been desperately trying to increase consumerism back at home – but the fact is asian societies have a savings oriented culture and we dont overspend beyond our income. What is happening today in Indian urban jungle in the form of loads of EMIs and credit cards is the currently flawed US model of “spend first earn next” – which is a call for disaster in the long run – and we should be all avoiding it as much as possible, if we are to prevent a US like slowdown here.

      Asia is a huge market in itself – and India is a huge market in itself – if our governments initiate large scale infrastructure development projects – invest in research – give boost to home grown industries in all sectors including defense – and stay away from the US model of over spending – we can create a healthy economy with a balanced consumerism-savings oriented growth – which is a sustainable model. But given the influx of American over spending culture in our economy – even though currently limited to few metros and large cities in the country – if we are to look for long term economic stability, we should definitely be controlling our spending.

      Any cut down in US expenditure is definitely going to affect the global economy which today largely has a basically flawed model of Asian exports drive by American (to some extent European) Consumerism. Given the impact of the Subprime Crisis, today US actually has to increase its spending to create more jobs back at home, for people can spend and keep the economy rolling only when they have income. And that was Obama’s plan as well when he came to power, to massively invest on public infrastructure projects to boost job creation.

      Now there is slow down and US consumerism is going down, which means rest of the world will see less dollar inflows, which means less dollar with large economies like China, India, Japan etc to invest back into US treasury by lending their earned dollars to US government. So in the coming years, even if US continues to borrow more and raise the borrowing limit, there is simply not enough dollars to lend it to US, so US will have to print more and more dollars to fund its economy, and that means a depreciation in the value of dollar, which in turn means appreciation of the value of other currencies visa-vis dollar. Which is why China for quite some time has been demanding the removal of US dollar as world currency, and to introduce other currencies as major players in world economy so that there is a more balanced world out there with the dependence on a single currency removed.

      As it was published in some US magazine some time back, what is taught in the name of macro economics based on capitalism and consumerism in the western universities – is actually a total waste of time and meaningless. Unfortunately we have a lot of those american educated economists establishing businesses and creating policies back in India here today :)

      • sainath

        Then this means for IT industry there is definitely going to be cut in JOB outsourcing from US to India, and this will again cause layoff’s in India ???

        • Anonymous

          As long as Indian IT services continued to be closely dependent on US outsourcing, this is bound to continue. Everytime the US sneezes, the Indian IT professional not just catches cold, but almost loses his nose :)

  • Mohankp23

    very interesting piece of writing. but I am  unclear at the end of the article whether the US will raise once again from the dust and storm and if so, when.

    • Anonymous

      Given its massive technological, economic, defense, scientific might I guess US will make sure it continues to be a global power, it can manufacture its rise if need be, and presently all it needs is a manufacturing of stable economic policies which can fund its economy for another 40-50 years. It has done this earlier in the past, so I am sure it will do it now and in the future too.