The debt ceiling has been a controversial topic recently. It will no doubt make headlines again early next year when another increase is needed to prevent the U.S. from defaulting on its sovereign debt. But what exactly is this device that the capital seems fixated on? Below is a 15-point lesson on the debt ceiling and sovereign defaults:
1. The US debt ceiling is a legislative limit on the US Treasury's ability to borrow money. It was first created in 1917 and can be modified by Congress.
2. Before the debt ceiling was raised this month, it stood at $16.69 trillion. Total US debt exceeded this amount last week. Thus, if Congress had not reached an agreement to increase the ceiling, the US might have been in default on its debt (unable to meet its obligations).
3. As of this month's agreement, the debt ceiling has been raised 79 times since 1960.
4. Creditors to the US -- the parties from whom it borrows money through instruments such as bonds and notes -- can be divided into four categories: (a) foreign governments and entities, (b) the American public sector, (c) the American private sector, and (d) other US federal government agencies. Here are some examples of each:
5. Domestic investors hold approximately 66.5 percent of the Treasury's debt. Despite the media's emphasis on US indebtedness to China, only 7.65 percent of total US debt belongs to the Chinese government. In fact, the US Social Security Trust Fund holds double that amount.
6. The important metric is not the total amount of a country's debt but the ratio of its debt to its Gross Domestic Product (GDP). Governments have outstanding debt even when they are economically thriving; only when a nation's debt is too large relative to the size of its economy is there cause for concern.
7. The current US debt to GDP ratio is roughly 106.8 percent, meaning that the amount the federal government owes to its creditors exceeds its GDP. Although this is undesirable, the ratio has been even less favorable in the past. In 1946, US debt as a percentage of GDP reached 121.7 percent. In contrast, it dipped as low 32.5 percent as recently as 1981.
8. The US has defaulted on its debt before: first in 1790, and then in 1933 and 1979.
9. The agreement announced by the Senate last week will fund the government until January 15 and allow it to borrow until February 7. At that point, further negotiations will be needed. US debt is expected to increase, so whether and by how much to raise the debt ceiling will again be at issue.
10. If the US defaults on its debt in February, its creditworthiness could suffer. This might happen formally and/or informally:
(a) Formally: The more likely a debtor will repay the money it borrows, the higher their credit rating is. Credit rating agencies such as Fitch Ratings and Moody's currently rate US bonds at AAA, the best possible score. This means that US Treasury bonds are considered among an investor's safest options. Investors who are risk averse or trying to balance out other risky investments accept lower returns on these bonds in return for that reassurance. The rate of return demanded by investors is the debtor's cost of borrowing money, so high ratings are very desirable because they reduce the borrower's overall cost of capital. US Treasury bonds have historically been viewed as "risk free," allowing the federal government to borrow money from investors at extremely low rates relative to other securities. If Treasury bonds are downgraded, the US government's cost of capital would likely increase to its detriment.
(b) Informally: Even without Treasury bonds being formally downgraded, investors might demand higher returns in exchange for the new perceived risk of Treasury bonds. Since yields are determined by the capital markets' required rate of return for any given security, the perception of risk can be just as important -- if not more important -- than the reality.
11. Sovereign defaults and debt restructurings have historically followed the contraction of a nation's capital market or the devaluation of its currency and have been quite commonplace for certain nations. For instance, Spain has defaulted six times and Venezuela has defaulted ten times.
12. There have been hundreds of sovereign debt defaults and restructurings since throughout history. Between 1981 and 1990 alone, 74 defaults occurred.
13. The US Bankruptcy Code provides guidelines for the debt restructuring of insolvent or illiquid municipalities (Chapter 9), organizations (Chapter 11), and persons (Chapter 13). However, it does not account for the federal government defaulting on its debt.
14. The international community has not adopted a universal set of procedures for administering sovereign defaults. A country's inability to meet its debt obligations is addressed on an ad hoc basis. For instance, some debtor nations receive loans from the International Monetary Fund.
15. Due to increasing globalization of capital markets and interbank lending, there are many advocates for the implementation of international restructuring procedures. For instance, Jeffrey Sachs of the Earth Institute has said that bankruptcy law is necessary in a modern economy since "markets cannot handle situations of extreme financial distress or debtor- creditor workouts in an efficient manner without a sound legal framework.