The idea of a debt ceiling is to place a limit on how much the government can borrow. (you could think of it like a limit on your credit card)
For example, in July 2011, the US debt ceiling was $14.3 trillion (£8.8 trillion)
The idea of having a debt ceiling is that
- The government knows it can’t allow debt to rise above a certain amount. Therefore there is greater incentive to pursue politically unpopular policies such as cutting spending and increasing taxes to prevent debt increasing above a certain level.
- A debt ceiling should also reassure bond investors. By placing a limit on the amount the government can borrow it should prevent the government taking too much on leading to debt default.
- If the government does need to raise the debt ceiling, it offers a chance for politicians to review where the government is spending money and prevent unnecessary spending.
Problems of Debt Ceilings
- There can be good reasons for increasing the level of government borrowing. For example, in a recession, government borrowing automatically increases. Allowing higher levels of government debt may be necessary to stimulate the economy.
- In times of a recession / liquidity trap, bond investors are willing to buy more debt at low interest rate. For example, although US borrowing is getting close to debt ceiling, bond yields have remained very low. This suggest markets are willing to keep buying US bonds.
- A debt ceiling creates unnecessary inflexibility. There may be times when it is advisable to reduce borrowing far below the debt ceiling (in times of growth). A debt ceiling makes no allowances for the state of the economy.
- Political wrangling. In the case of US arguments over raising the debt ceiling threaten to create political deadlock with parties unwilling to agree on a way to reduce borrowing in future; as a result parties are vetoing the increase in debt ceiling making it very difficult for the government to raise enough finance on bond markets. This could lead to a credit downgrade and loss of confidence.
- No Point. The US debt ceiling is routinely raised. If the debt ceiling is continually raised when necessary it raises the question of is it worth having in the first place. Members of the Euro were supposed to limit borrowing to 3% of GDP, but you now see members borrowing over 10% of GDP. Therefore, limits on government borrowing gain little credibility.