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Asked & Answered: Debt Ceiling Crisis

10/9/2013

 

Michelle from Minneapolis:

 

What is the Debt Ceiling and what is the big deal about reaching it?

 

Friedenthal Financial:

 

Michelle,

 

Certainly a popular question these days!  The debt ceiling is simply the maximum amount that the US can borrow at one time (currently $16.7 Trillion).  In each fiscal year, the government essentially has three components: 1) Revenue (taxes); 2) Expenses; and 3) Debt (borrowing) if the expenses are greater than the revenues.  Congress is actually the entity responsible for approving all three.  Since Congress approves the Tax Code (revenue) and the Budget (expenses), it’s implicitly approving the incremental debt, which is simply Expenses minus Revenue.

 

The Constitution (14th Amendment, Section 4) requires that the US always makes good on its financial obligations.  The Constitution also requires that the US abide by the laws set forth by the Congress…which includes BOTH abiding by the budget established AS WELL as the Debt Ceiling.  Clearly all three of these things are inherently in conflict with each other if the debt ceiling is not increased.  Some law is likely to be broken if Congress doesn’t raise the debt ceiling in the near term.  It’s not clear which one, and by whom it will be ultimately decided.

 

Congress & the President have both stated that they would like a plan to balance the budget (make revenue and expenses equal) over some period of time.  How, and over what period of time, has been the source of much disagreement, which has precipitated the partial government shut-down as of October 1.  Since no budget was reached, certain government functions go unfunded .

 

We think that it is still likely that Congress will at least temporarily increase the debt ceiling, to restart the government and remove short-term concern over meeting US obligations.  If that does NOT occur, let’s examine the two ensuing scenarios (in no particular order).

 

        1)      The President invokes the 14th amendment, and continues to incur debt, going beyond the debt ceiling, with the idea being that United States responsibility to pay its bills is the more important law than abiding by the debt ceiling itself.

        2)      The US immediately cuts roughly 30% of its expenditures (According to the Congressional Budget Office, the US takes in about $2.7 Trillion in revenue and spends about $3.55 Trillion in expenses during the current fiscal year.), which balances the budget instantly overnight and keeps the debt constant.

 

The first scenario would clearly get challenged legally and probably go to the Supreme Court to determine its validity.

 

In the 2nd scenario, it is unclear which government expenditures would be cut.  Our belief is that the interest on our debt (T-bills, notes, bonds) would continue to get paid.  Because interest rates are low, this only amounts to roughly 12% of the current US budget.  However, some government contracts may not get paid.  Bigger fears over delays in Social Security and Medicare benefits loom as well.  Besides the obvious ramifications to the businesses and individuals relying on these government payments, there may be longer term legal and credit ramifications of the US not fulfilling its obligations.

 

Even though a balanced budget is desirable in the long run, forcing it instantly will slow growth in the economy as those business and individuals who did not get paid, stop paying for other goods and services.  The longer this scenario continues, the more likely, and potentially deeper, the economy goes into recession.  Perhaps most ironic – a slower economy produces less in revenue (taxes), which would likely increase the budget deficit, and necessitate even MORE cuts in spending, or increases in tax rates (or an increase in the debt ceiling).

 

Let’s all hope that cooler heads prevail in Washington, at least temporarily increasing the debt ceiling.  This would allow for a thoughtful bi-partisan agreement on a long term balanced budget that won’t slow growth in the economy.

 

The Friedenthal Financial Team

856-210-6494 (Office)

856-210-1565 (Facsimile)

info@friedenthalfinancial.com

www.friedenthalfinancial.com

 

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