To recap, the debt ceiling is a mechanism that allows the government to increase its borrowing capacity in order to honour previous obligations. In today's editorial we will describe why there is a debt ceiling and why it poses such a serious risk to the US economy.

Why the ceiling?

Typically when the US government proposes a federal budget it looks at the amount of tax revenue coming in versus the amount of spending required. If tax revenue exceeds spending, the government operates a budget surplus.

When spending exceeds tax revenue, the government makes up the shortfall by borrowing money. However approving spending and raising the additional debt are two separate things under US law.

Congress may approve a budget (or a law that requires spending), but the deficit is only financed when the debt ceiling is raised. Throughout the history of the US, the debt ceiling has routinely been raised in order to continue spending that has already been approved by Congress.

However approving a budget with deficit spending and borrowing the actual money to finance the spending are two completely separate things from a legislative perspective. Congress passes a law approving spending and then must pass another law authorising the borrowing needed to finance the spending.

21^st century

The debt ceiling has taken on added significance throughout the 21^st century because of the sheer scale of debt the government has racked up. The last time the government ran a surplus was back in 2001. From a surplus of US$127.3 billion in 2001, the US has racked up 12 consecutive years of deficits.

Following the GFC in late 2008, the government posted a record US$1.4 trillion deficit in 2009 as it undertook emergency stimulus measures to rescue the economy.

In each of 2010, 2011 and 2012, the budget deficit topped US$1 trillion as tax revenue shrank due to high unemployment and a tepid economic recovery. The continuous run of deficits has resulted in an exponential increase in gross federal debt over the past 12 years, as the chart below shows:

What happens if the ceiling is hit?

We know that for every year of deficits, the government must increase the debt ceiling in order to finance spending obligations. Now we address what happens if the debt ceiling isn't raised. Specifically, what if the government has already committed to a spending program but finds that it is unable to borrow the money because lawmakers refuse to raise the debt ceiling?

Remember that tax receipts and borrowings together are used to finance government spending. Because there is no new borrowing, tax receipts alone will be insufficient to meet all spending requirements.

The US government would not be able to fund things like welfare payments (including jobless benefits), and it would almost certainly be forced to default on some of its obligations, including those to its creditors.

Many economists expect a US default will spark a new financial crisis. The convulsions in bond markets would create upward pressure on US interest rates, worsening the deficit as well raising borrowing costs for businesses and consumers alike.

It would also mean that the limited amount of government revenue would have to be diverted from essential programs to pay for escalating interest costs.

Ultimately, the US economy would crash under the weight of a deep recession and a government default. Understandably, a US default would have serious implications for the world economy. Even the threat of default would be enough to send markets into a tailspin.

In next week's editorial, we will conclude our discussion on the debt ceiling by assessing the likely market reaction to the debt ceiling standoff and look at why the debt ceiling has become such a hot button topic among US politicians.

Dancing On The Debt Ceiling is a post from: Australian Stock Report Market Pulse Blog