Hot Topic: Making Sense of the Debt Ceiling

CNBC and Bloomberg Television, Longo has taught in Rutgers’ undergraduate, MBA, Executive MBA, and International Executive MBA programs for more than a decade.

Rutgers Today: Can you explain the meaning of a “debt ceiling” to those of us for whom economics is not our native language? To whom, exactly, does the government owe this $14.2 trillion?

Longo: It actually owes it to two broad groups or parties. One is the people and entities who have bought U.S. Treasury securities, roughly half of whom are foreign investors – China and Japan are the biggest creditors of the U.S. Treasury, holding 26 percent and 20 percent, respectively, of outstanding debt obligations. The other is payment to keep the federal government running and meet its obligations:  employees, members of the military, vendors – anybody on the government payroll – as well as entitlement programs such as Social Security and Medicare.  

Rutgers Today: What does it mean that the United States government hit its debt ceiling on May 16? How did we get into this jam?

Longo: We got into the jam for two reasons: a weak economy and, generally, politicians like to spend. Our expenses are greater than what we are getting in taxes and fees and other revenues. We have had a deficit in excess of a trillion dollars a year over the last three years. In order to keep borrowing money, it has to be authorized by Congress, and they’re holding it up because the members – at least on the Republican side – want to see a larger reduction in spending.  President Obama seems to be willing to make some spending cuts, but he also wants to raise taxes to help close the budget gap.

Rutgers Today: Who determines the “ceiling” in the first place, and who set the deadline – August 2 – that Congress and the president are haggling over?

Longo: The U.S. Constitution provides that Congress has the sole power to borrow money on the credit of the U.S. Government.  The August 2 deadline is somewhat arbitrary. It’s like balancing a checkbook: You calculate that you’ll be able to pay your bills until August 2, and thereafter there will be problem. You see bills coming in and your checking account is almost on empty. You can do a home equity loan if you are an individual; if you’re the government, you can issue more U.S. treasury securities – provided Congress approves.

Rutgers Today: How have previous administrations handled the situation?

Longo: Some accounting gimmicks can be used to extend the deadline, perhaps by two or three months. For example, the government can take longer to pay contractors .Theoretically, you can delay paying people in the military. You would not want to default on your debt; that’s the worst-case scenario. You triage who will get paid. The U.S. treasury is the main entity that does this triage. There is a limit to this, perhaps three months maximum. There’s only so much fat you can cut, and then you’re literally going to be out of money. It has never happened. If we were to default on the debt, it would be a financial disaster. The United States would lose its AAA credit rating, leading to a snowball effect that could result in selling across global financial markets.

Rutgers Today: If August 2 comes and goes without an agreement, how will it affect the average American? What will it mean for the U.S. economy – and, by extension, the world economy?

Longo: Again, the deadline might be able to be extended couple months or so, but the financial markets wouldn’t like it. Interest rates would up, the markets would get skittish. After the accounting gimmickry winds up, financial disaster may follow. The fact that the U.S. has never defaulted – as, say, Russia has – is one reason why we are viewed as a strong financial market.

Rutgers Today: What options does the government have to ward off the same situation in the future, given that the debt ceiling has had to be raised 74 times since March 1962 – 10 times in the past decade alone.

Longo: The main thing is to get spending under control. Medicare and Social Security are among the largest expenditures, as well as the defense budget. To have a truly meaningful deduction in the federal debt, there will most likely be a reduction in Medicare and Social Security,  extending the retirement age, for example, or increasing co-payments. Just like any individual, you can’t spend more than you make in income. The way the economy is now, we will have large deficits some time to come. An increase in taxes may also reduce the size of the deficit, but I believe too much taxation can also drive away business activity.