The Economist explains - Why does the debt ceiling matter?

THIS WEEK much of America’s government shut down when Republicans and Democrats failed to agree on a budget. Soon, America will hit a more disruptive deadline: its statutory debt ceiling.

What is it, and why does it matter?

The first thing to clarify is that a government shutdown due to failure to pass a budget and a shutdown due to failure to raise the debt ceiling are different things with different implications. In America many government functions—such as defense and the national parks—must be funded by annual acts of Congress called appropriations. If Congress fails to appropriate funds, the activity must cease, with exceptions for essential services.

Shutdowns are disruptive and a bad way to make policy but do not force the government to renege on anything it had promised to do.

The debt ceiling is different. Congress has from America’s earliest days placed limits on how much debt the Treasury may issue.

From 1917 to 1935, Congress gradually granted the Treasury more flexibility until a single debt ceiling was established. The debt ceiling only matters when the government runs a deficit. If it collects $20 in taxes and has $25 in spending commitments, it must borrow $5, raising the national debt by $5. But this can put different laws in conflict.

Congress may bless spending and tax laws that arithmetically compel the government to run a deficit, but not authorize a high enough debt limit to finance that deficit, so the Treasury could not meet some of its legally required spending commitments. America shares this quirk with almost no other countries (Japan and Denmark) have a debt limit but for a variety of reasons, neither pose serious constraints on the government’s actions).

The Treasury reached the current debt ceiling of $16.7 trillion on May 19th. Since then it has temporarily cut its borrowing from various internal accounts, using the resulting room to keep issuing Treasury bonds and bills. But it says it will exhaust those “extraordinary measures” on October 17th. Then what? The Treasury can make some payments out of current tax revenue and $30 billion of cash reserves. But within a matter of weeks it will have to withhold payment on something and thus, the Administration says, default on its “obligations”.

That does not necessarily mean defaulting on its debt. It can still refinance maturing debt, since that won’t raise the outstanding amount. To avoid defaulting on an interest payment it could “prioritize” such payments out of incoming cash (a tactic many analysts expect). This would mean reneging on even more of its other obligations, whether Social Security, medical payments, military deployments or food stamps.

If the government were forced to cut spending immediately to match incoming revenue, it would impose a hit worth 3.4% of GDP over a full fiscal year.

Even if the Treasury sought to prioritize interest payments, it might miscalculate and miss a payment.

That would be virtually without precedent, and quite bad—just how bad, nobody knows. A lot of the American and global financial systems depend on the risk-free nature of Treasury debt. Central banks and other official investors would reconsider holding as much Treasury debt and banks would have to decide whether to classify such holdings as non-performing. Countless transactions that rely on Treasuries as collateral or as a reference price might have to use something else.

Still, the full consequences of the world’s biggest, most important borrower defaulting are largely unknowable. Suffice to say that after two financial crises in the last five years (America’s mortgages and European sovereign debt), a third is the last thing the global economy needs.)

Read article here from The Economist