The federal debt limit is again in the news as the country rapidly approaches a critical deadline on June 1. Investors are understandably nervous about Washington failing to reach an agreement, a possibility that both sides agree would be a self-inflicted catastrophe. While it’s unclear how this will play out in the coming weeks, the financial markets mostly take these events in stride. How can investors maintain the proper perspective around political and fiscal uncertainty?
Federal borrowing reached the debt limit this past January
First, it’s essential to understand what the debt limit is and is not. Simply put, the federal government borrows money to pay its bills by issuing Treasury securities. This is necessary because the federal government often operates with a deficit whereby spending (on defense, Social Security, emergency pandemic stimulus, and more) exceeds government revenues (primarily tax revenues). While tax revenues increase as the economy grows (even without raising tax rates), they have been outpaced by spending over time. This borrowing adds to the national debt, which hit the $31.4 trillion debt ceiling in January. Since then, the Treasury Department has employed “extraordinary measures” to ensure the country does not default on its obligations.
The debt ceiling is a mechanism that requires Congress to approve additional borrowing above these levels. Thus, this discussion is confusing because the debt ceiling is not about government spending per se. That spending has already been authorized through the normal budget process each year.
Thus, the only question around the debt ceiling is whether the government can and should pay its bills. This is akin to signing the papers for a new car and requesting an increase to your credit limit afterward. For most of us, the decision to buy something can’t be separated from whether we will pay for it, even with debt. Unfortunately, the Congressional process for approving a budget by September 30 each year is separate from whether the Treasury can actually pay the bills.