The Debt Ceiling–what happens if the debt ceiling is not raised?

29 07 2011

I previously wrote about the debt ceiling.  In my first post about the debt ceiling I explained what the debt ceiling is and briefly touched upon the direct effects of not raising it.   I concluded with the only two clear conclusions that can be drawn:

“(1) we are not facing a total shutdown/Armageddon and (2) some people will be affected.”

In my second post, I gave the analogy of a credit card to explain that the Federal government “WILL still spend money, but only equal to the amount they bring in.”

In this post, I will step out on a limb and read the tea leaves to try to predict more direct effects from hitting the debt ceiling.  It is easy to say “we won’t have a total government shutdown” or “some people will be affected,” but it is much harder to say what the actual effects will be or who will be affected.  As with everything we post – this is not legal or financial advice, it is just a very brief, very rudimentary analysis.

The first thing to do is to start with what we “know” (I put “know” in quotes because I am getting this from the Wikipedia page on the U.S. Deficit, which is probably accurate, but I have not cross-checked this information with the official public reports):

(1) the Total debt is roughly $14.46 TRILLION, which is almost equal to the entire U.S. GDP in 2010.  GDP is not revenue (taxes are revenue).  Basically, GDP is the value of all goods and services produced in the entire country in one year.  It is important to note that U.S. GDP is calculated by adding together Consumption, Investment, Government spending, and net exports (which in turn is calculated by subtracting imports from exports).  There are different models of calculating GDP, but this is the one that is used to report U.S. GDP. 

(2) The 2010 deficit is approximately $1.6 TRILLION.  In other words, the government spent $1.6 TRILLION more than they brought in.  They had to borrow at least that much money.

(3) If the debt limit is reached, the deficit automatically becomes zero (because no further borrowing is possible).  The budget instantly becomes balanced.

From the above, we know that slightly more than 10% of GDP will be immediately taken out of the GDP calculation.  That’s a very large amount.  Directly affected will be government contractors – the government will no longer be able to pay those contractors, and that will have a trickle down effect.  Also, this will move the GDP number into recession territory.  Beyond that, it is hard to know who will be affected.

Since government spending is such a huge part of GDP, it becomes clear that the private sector is hurting and the government spending is masking some of that pain.  But that pain still exists in reality, it is just not reflected in the numbers.

So, from the above, we would expect the economic numbers to reflect a significant decline.  The people directly affected will be government contractors, and people in that chain.  It may also affect interest rates and the stock market, which then has ripple effects.


The U.S. Debt Ceiling–a simple analogy

20 07 2011

In a past post, I gave an overview of the debt ceiling issues.  I recently explained this to a very confused colleague using a simple analogy:

Let’s say you have a monthly income of $1,000.  Your basic living expenses are $700 a month, leaving you with a “surplus” of $300 a month.  Due to elements out of your control, you cannot change your monthly income (despite repeatedly asking your boss) and you cannot decrease your living expenses.  That is, the bare-minimum necessary for you to survive every month is $700 and the most money you can possibly earn every month is $1,000.

You have options on what to do with that $300 though.  You can save it or spend it.  In this example lets pretend that the only way to save it is by putting the surplus in a jar in your closet. If you save it, you can spend it in a later month.  For instance, if you save $300 one month, you now can spend $1,300 the next month (your $1,000 income check plus the $300 that you saved).  Or you can spend $1,150 next month and $1,150 the month after.  Or you can continue to save $300 a month, or whatever you want to do.  But you can never spend more than your monthly income PLUS whatever you have saved up in the past; that is you can never spend more than what your boss pays you that month PLUS the amount in your jar.

Given the above scenario, everything is fine and simple.   Life goes on, sometimes you save a portion of your $300 surplus, sometimes you spend a portion of your savings, etc.  One day, you get a credit card.  Your credit card has a cap of $5,000.  The credit card allows you to borrow any amount of money at one time, up to $5,000, or you can borrow in increments.  The credit card acts almost exactly the same as your jar – you can take money from it, or put money back into it.  The big difference is that you can never take more than $5000 out and you will HAVE TO put the amount of money that you took out back into it at some point.  So if you take $100 out, you will eventually have to put $100 back in.  The other big difference is that you have to pay interest on what you take out, so if you took out $100, you might eventually have to pay back a total of $150 over time.

There are only two hard and fast rules attached to this particular credit card: (1) you can never take out more than $5000 at a time, including accrued interest and (2) as long as you pay your minimum payment every month, you are not in “default.”

You decide that since you now have this credit card, you can spend more than $1000 a month, so you do.  You buy all kinds of fun stuff, so your monthly expenses end up $1,200, month after month. You spend every dollar in your jar as well since you had some saved up.  But every month you continue to pay your minimum payment.  Pretty quickly though, you reach your cap and can no longer spend extra.  Due to the large balance, your minimum payment every month is $300.  So now your income of $1,000 a month exactly meets your bare necessities PLUS your minimum required payment to avoid default.  You can no longer buy anything excessive since you have spent your savings and maxed out your credit card.

The important thing is that you are NOT in default.  You just have to cut back on the $200 excessive spending a month that you have grown accustomed to.  You also won’t be able to save any money or have the benefit of occasional splurges that you enjoyed in the past.

This is the situation the U.S. Federal government faces – they have maxed out their credit card, so they need to cut back.  They WILL still spend money, but only equal to the amount they bring in.  Right now, and for the foreseeable future, the amount they bring in is enough to cover their minimum “monthly payments” on the credit card as well as their “crucial living expenses.”

The Debt Ceiling–an unbiased primer

12 07 2011

The U.S. Federal government will soon hit its debt ceiling.  This information has been in the news for some time, often with predictions of “doomsday” if the ceiling is not lifted.  Most of the news on the ceiling does not explain, in any sort of detail, explain what the debt ceiling is, why it is a perceived problem if we “hit” it, and why raising it is a solution to anything (other than to “hitting” the ceiling).  Here is a brief, unbiased explanation of what the debt ceiling is and its effect so that you can decide if it is a problem.

It is easy to explain “what” the debt ceiling is: the Federal government has a cap on the amount of money it can borrow.  If the Federal government reaches this limit, the Federal government can no longer borrow any more money.

What the debt ceiling is not: in the above, notice the emphasis on the word “borrow.”  The debt ceiling is NOT a limit on how much money the Federal government can bring in or spend.  For instance, in 2008, the Federal government brought in $2.66 TRILLION from taxes.  That money is unaffected by the debt ceiling, the Federal government will still collect a similar amount each year no matter what happens with the debt ceiling.  If the Federal government were a business, this would be its “Revenues.”

That same year, the Federal government spent $2.9 TRILLION.  If the Federal government were a business, this would be its “Expenses.”  Obviously, the Expenses were more than the Revenues, which leaves a “deficit” instead of a “surplus.”  The only way to spend more than you make from the ordinary course of business, is to borrow the difference.  That difference gets added to the negative balance that has accrued from past years, which is the total debt amount.

As you can see, if the Expenses are less than or equal to the Revenues, there is no deficit and no additional debt.  In other words, if Expenses are the same as Revenues, the Federal government does not move closer to the debt ceiling and the debt ceiling has absolutely no effect on anything.  Similarly, if Expenses are less than Revenues, the Federal government actually moves away from the debt ceiling, and again, the debt ceiling has absolutely no effect on anything (other than to leave more “room” for borrowing in the future).

So why might it be a problem to reach the debt ceiling? If the Federal government cannot borrow any more money, then the most it can spend is the amount it brings in.  Any spending beyond its revenues is impossible (more accurately, any spending beyond its revenues is unconstitutional).  In other words, it can “only” spend $2.66 TRILLION a year (if we use 2008 numbers), and will be forced to cut discretionary spending.  In 2008, mandatory spending was $1.788 TRILLION, the rest was spending.  So the Federal government will still be able to cover all of it’s “mandatory” spending, which includes: Social Security, Medicare, Medicaid, and Federal debt interest.

Notice that Federal debt interest is a “mandatory” expense.  This prevents a default.  But the Federal government will be forced to cut “discretionary” expenses.  It will do this by laying off some Federal government employees and cutting back on some benefit programs.  These programs can grow in the future as revenues grow, or the Federal government can leave them at a smaller size and have a surplus in its budget.

Will these cutbacks affect you? That is for you to decide.  Two things are clear though: (1) we are not facing a total shutdown/Armageddon and (2) some people will be affected.