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Debt Ceiling 101

Here we go again! We just avoided the fiscal cliff and now we’re headed for the debt ceiling. Misinformation and half-truths are the headlines of the day as the political rhetoric rises. So in this Prosper On I want to set the record straight. I’ll start with an explanation of the debt ceiling and then take a look at the arguments for raising it and why that’s not the best idea. We’ll get started with an example.

Let’s use our fictional character Bob. Bob has a credit card and was doing a good job paying off the balance every month. Along came an unexpected expense like an auto repair or emergency. Now normally this would be no problem for Bob, but money was tight that month and he decided to keep a small balance on his credit card. The balance was so small he didn’t notice the 20% interest charge.

Then Bob saw a new snow blower he had to have, so he added the purchase to his card. Over time, his balance grew and grew, until Bob could only afford the minimum monthly payments. Eventually his balance hit the card’s credit limit, so the bank stopped lending him more money until he paid down the balance.

This simple example is no different than the United States debt crisis. Essentially the country has maxed out its credit card and now it’s asking for a credit limit increase. But if banks won’t lend more to someone with a maxed out credit card, why would congress be OK with increasing the debt ceiling?

The primary argument for raising the debt ceiling is to prevent the United States from defaulting, but that’s flat out wrong. By definition, the U.S. can only really default if it fails to pay its mandatory obligations, like making interest and principal payments on its debts. The decision to make mandatory payments falls with the Treasury and given their cash flow they’ll likely pay the bill. However the U.S. would have difficulty keeping all discretionary obligations fully funded.

This leads to the second most common argument: the threat of a government shutdown should we hit the ceiling. This means suspending parts of the government because the Treasury lacks the authority to spend any more money. In essence, spending would be limited by incoming revenue. But all big organizations have contingency plans and our government is no different.

First, spending is divided into two types, mandatory and discretionary according to The Center Forward. Mandatory spending, which accounts for approximately 60% of the US budget, is money the government must spend because of laws defining who is entitled to it and in what amount. A few of the most significant examples are:

  • Medicare
  • Medicaid and food stamps
  • Unemployment Insurance
  • Veteran’s Benefits
  • Interest on government debt

All other spending is considered discretionary. Half of those funds go straight to defense. Other examples include:

  • Salaries for federal workers and congress
  • Funding for federal agencies
  • Schools
  • Highways
  • National Parks

If the government were to shut down, money would continue to flow into the Treasury through taxes and fees. According to The Heritage Foundation, mandatory spending would continue as required by law. Once all those obligations are fulfilled, discretionary spending would continue, but only to match incoming revenue. Expenditures exceeding revenue will then be prioritized and paid in order. Essentially the U.S. can only spend what it makes, as it makes it.

Our original example makes the debt ceiling easy to understand. The United States has maxed out its credit card. Should congress allow the country to raise its limit, or should it be forced to pay for only what it can afford? I think when the political hyperboles are removed, the choice is clear. I think raising the debt ceiling only invites the country to dig itself into a deeper hole instead of addressing the real problem with its budget.

Craig Arfsten

Craig Arfsten

As a Prosperion Advisor, Craig has the independence, support and resources to help clients with what he does best – listening to their stories, discovering their desires, and identifying their greatest financial risks, before developing a comprehensive approach to meeting those needs. Learn more about Craig here.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

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Sources:
Default, Wikipedia, http://en.wikipedia.org/wiki/Default_(finance)

“Mandatory” Knowledge: Truths About Government Spending, Center Forward Budget Basics, Vol. 1, No.2, updated March 2012.

Debt Ceiling: Default Not at Issue, Federal Spending Is, Heritage.org, Jan. 14, 2013, http://blog.heritage.org/2013/01/14/default-not-at-issue-federal-spending-is