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Yahoo U: What does it mean to raise the Debt Ceiling

Yahoo Finance’s Brian Cheung joins the Yahoo Finance Live panel with today’s Yahoo U: Debt Ceiling

Video Transcript

ZACK GUZMAN: Welcome back to Yahoo Finance Live. As we've been documenting for the last couple of days here on the show, the government is trying to avoid a shutdown. And they need to raise the debt ceiling here to do so. And it's looking unlikely that we're going to see any updates until at least Monday when we see a vote there. But what does it exactly mean to raise the debt ceiling? Well, here in this week's Yahoo U, Brian Cheung breaks it down. Brian.

BRIAN CHEUNG: Well, Zack, class is in session. And Treasury Secretary Janet Yellen has warned of economic catastrophe if Congress doesn't raise the debt ceiling. Now it sounds a bit dramatic. But it really is that serious for reasons that I'll explain. And that's because this all concerns the government's ability to pay its bills. And if you can't pay the bills, well, that's not good. And that's where we begin here with our lesson today.

And it's important to remember that the government's bills aren't quite the same as our bills, right. So they issue bonds. So for example, a person might buy a 10-Year Treasury with a value of, let's call it, $1,000. Now this is really a loan to the government, right. A lot of people will be familiar with this idea. And in turn, the government promises to pay you interest. So let's say it's about 1.6% annually, not that much. But you have to get something for, essentially, giving the government a loan.

Now, in the aggregate, right, multiply this by trillions of people, trillions of bondholders, it's all this money that supports government spending, right. This is how the United States raises money to finance defense spending, or infrastructure, or social security. Now, the debt ceiling is a mechanism that our government has used to put a cap on the amount of aggregate debt that's out there, hence a ceiling, right. And the idea behind a statutory limit is to effectively put a cap on government spending, right. But don't get it twisted, because this isn't a budget. This is important here.

The actual mechanism of a debt ceiling is to freeze the United States Treasury, which issues those bonds, from issuing new bonds. Because, again, the debt has now surpassed the ceiling. And that's one major problem with the debt ceiling, which is something that Congress debates and legislates into law. It doesn't actually stop government spending, right. It doesn't stop the ability of the government to pass more defense spending or a coronavirus relief bill, for example.

And that's because any legislation that already previously authorized spending still needs to be paid for. But if the debt ceiling is back in place and we're past the debt ceiling, ultimately, the Treasury can't raise more money to ultimately pay for the things that may have already been authorized to be spending. Now the current kerfuffle, if you want to call it that, over the debt ceiling is not new, right. But for the most part, you can see that over time the federal debt has expanded. And Congress has agreed, oftentimes on a bipartisan basis, to raise the ceiling.

This chart is a lot. But the ceiling is in blue. This is, again, what Congress has negotiated as the new debt ceiling, which is in eye-popping numbers now in the Ts. The federal debt itself, the amount that the Treasury actually has outstanding as the bills it needs to pay, is illustrated here in purple. Now a major thing to emphasize here is that, yes, right now, right, this bit right here, you can see the purple is above the blue line. So we have more debt than the current debt ceiling, which is about $28.5 trillion.

The reinstatement of that 28.5 number is something I'll get into in a second. But, again, what is the reason for why we're above the debt ceiling now, right? This is not the infrastructure bill that the Biden administration wants to get into place. Because that hasn't been passed yet. A lot of what this is, this accumulation of debt that surged past the ceiling, is actually the explosion in the CARES Act spending, right, over $3 trillion in total that were spent to try to keep households and businesses whole during a pandemic.

And it's important to remember that the debt ceiling that we face now was not negotiated before the pandemic happened. So no one anticipated the United States having to take on trillions of dollars or debt when they were debating the debt ceiling the last time they had that conversation, which brings us to where we are today. So if you rewind to August 2019, again, that was really the last time that Congress had a robust discussion over where to put the debt ceiling.

There was a bipartisan budget act. As part of that, they suspended the limit through July 31, 2021. They said, let's just punt it. We'll have no limit through the end of the next two years. You fast forward. We went through an entire pandemic, are still in one. And as of August 1 of this year, the debt limit was reinstated. And there's a mechanism in place where they account for whatever the debt level was at that time. $28.5 trillion is the estimate.

We are still blowing through that, because we're trying to cover bills that, again, were appropriated and budgeted out for spending before the debt limit was put back in place. Now it's not all doom and gloom as of the day that the debt limit is put back in place. And that's because the Treasury has a reserve of cash that they can use to tap into to pay the outstanding debt in the meantime. Now, the problem is that, at some point, that reserve is going to get blown through. And the Treasury expectation is that they'll run out of cash sometime in October or November, so not necessarily good.

Now, if that does happen, what does that mean? That could mean possibly defaulting on all of that debt. Now imagine what would happen if that were the case, as I kind of wrap up my slides here. If the government couldn't pay its bills, if there were outstanding holders of US treasuries that couldn't get their money back, that might affect the creditworthiness of the United States. You might have ratings agencies that downgrade the United States.

And then also keep in mind, the US Treasury market is supposed to be the most liquid market in the world. It's an index and a benchmark for risk rates. That could create a whole financial market implosion, not just in the United States but in the world globally, which means that it's really not quite an exaggeration for the Treasury Secretary to say it could cause widespread economic catastrophe if it is indeed the case that the United States doesn't have the debt ceiling put back in place.

So a little bit of a scary scenario there. But, again, we have until October or the end of-- or possibly into November to deal with that. We'll see if Congress can get that through. But that wraps up this week's Yahoo U, guys. A little bit of doom and gloom situation there but, hopefully, someone glean something out of that, at least from Congress' point of view.

ZACK GUZMAN: Yeah, and I mean not what you want to see happen, especially now when you've got China dealing with their own issues, too, with Evergrande. But Brian, I mean, it sounds like you're saying there's a chance. If we even don't see the debt-- the debt ceiling raised here, a deal reached by the end of the month, that there's enough cash to hold you over through October to November, so maybe still, potentially, some wiggle room.

BRIAN CHEUNG: Yeah, certainly. We'll see-- we'll see if that is the case. But, again, not a lot of wiggle room there.