The Debt Ceiling Is The Real Battle

Last Updated Apr 10, 2011 12:36 PM EDT

Last week's political battle over spending cuts will look like child's play when it comes to the debate over raising our debt ceiling. So get ready for a political knife fight and probably some market turmoil.

You may not realize this, but the US has a self-imposed legal limit on the amount of debt the US government can borrow. This limit is called the "debt ceiling", and once the US reaches the debt ceiling, it can't borrow any more money unless Congress votes to raise the limit.
  • Now, don't mistake the debt ceiling issue with whether investors are willing to lend money to the US government. We can clearly borrow about as much money as we want from investors. There's been no lack of appetite for US Treasury bonds. Investors from all over the world continue to flock to them for their safety.
  • The question is whether we're allowed to borrow any more money, and that's dictated by the debt ceiling.
To understand the issue, you've got to get a handle on the basic budget numbers and why we need to borrow so much money.

The US debt ceiling is about $14.3 trillion. And right now, the US has debts of about $14.2 trillion. At the pace of our current borrowing, we've got about a month or so before we reach the limit.

The problem is that under our current budget, for every $1 that the US government spends, it collects about 60 cents in taxes. That means the US has to borrow the other 40 cents from investors. That borrowing is part of our annual deficit and gets added to our total national debt.

Last year, the US budget was about $3.7 trillion, but we only collected about $2.2 trillion in tax revenue. The $1.5 trillion gap was filled with debt. Basically we borrowed $1.5 trillion from investors. That's why we're rapidly closing in on the debt ceiling.

If the US doesn't raise the debt ceiling, then it will be required to live on only what it collects in tax revenue. That means we would need to cut the budget by 40% immediately. To put this in perspective, last week's debate about spending cuts represented only 1% of the budget. So you can clearly see that cutting 40% is basically impossible and won't happen.

That means the US will need to raise its debt ceiling so that we can keep the government running. The real battle will be over how much we raise it and what sort of budget cuts and revenue changes we put in place at the time we raise it.

For instance, Congress could agree to raise the debt ceiling by $1 trillion and then implement spending cuts of $100 billion.

But, even under optimistic assumptions about our deficit, we'll probably be running deficits close to $1 trillion for quite some time. That means we would hit the debt ceiling again in about a year.

Because we've borrowed so much and we're spending so much, this debate is something you're going to have to get used to over the next decade. We will keep bumping up against the debt ceiling as we continue to spend way more than we bring in from taxes.

The only way you don't add to the national debt is to run a balanced budget for the year. And we're a long way from doing that in the US.

Anyone who studies the US budget knows that the problem is driven primarily by health care costs. Medicare and Medicaid are the two programs that we just can't get a handle on. The reality is most people don't have enough money saved to cover the true costs of their health care as they age. So the government is going to cover it for them. But the costs are exploding so fast that we can't bring in enough in taxes to pay all the bills.

And with about 10,000 baby boomers turning 65 every day, each one of them is eligible for Medicare. Once retirees begin to understand the cost of health care, they'll fight tooth and nail against any cuts to Medicare. It just makes economic sense from their perspective.

Our long-term budget deficit debate is basically going to come down to a generational fight over who is going to pay the costs of retiree health care.

Bottom line. The debt ceiling debate will rage for years until we figure out a way to limit health care costs.

Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.
  • Charlie Farrell

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