This post offers a plain vanilla explanation of the debt limit. This is basic background aimed at fiscal policy novices. I oversimplify in a few places for ease of understanding and push some caveats and complexities down to footnotes. Some of my past readers may find this too elementary, but it’s a foundation I can build upon in future posts that will offer more detail and discuss the current stalemate.

The federal government’s fiscal year begins October 1, so federal fiscal year (FY) 2013 just ended and FY 2014 just began last week. In FY 2013 the federal government collected about $2.813 trillion in revenues and spent about $3.455 trillion. The difference between those two numbers, $642 billion, is the unified budget deficit for Fiscal Year 2013. We say unified budget deficit because we’re looking at all money flowing into the federal government (revenues) and all money flowing out (spending), and not distinguishing among different sources or uses of those funds. In other contexts, usually having to do with Social Security, we might want to treat on-budget and off-budget spending and taxes differently, but for this discussion we will use unified numbers.

I think of these enormous numbers as representing flows of cash. (Please see the footnotes below for two caveats: [1] [2]) The key question: if last fiscal year the government spent $3.455 trillion in cash but collected “only” $2.813 trillion in cash, where did it get the other $642 billion in cash it needed to pay the rest of its bills?

The federal government borrowed it. The Treasury department sold IOUs that we call Treasury bonds (technically bills, notes, and bonds, depending on the timeframe). Investors paid cash for these IOUs, and in exchange they got a promise that Treasury will pay them back later, in full, with interest, and on time. We say that Treasury issued debt to raise cash. Treasury’s issuance of debt is a means to an end: it is the mechanism Treasury uses to get the cash it needs to pay all the government’s bills (which we call government obligations) on time.

Treasury needs to borrow a lot because the deficit is big, and the deficit is big because the federal government is spending a lot more than it collects in revenues. If Congress and the President cut spending and/or raised taxes, then we’d have a smaller budget deficit and Treasury would need to borrow less. If we had a balanced budget, Treasury wouldn’t need any new borrowing, except to “roll over” past borrowing as it comes due.

The $642 billion deficit for last year is what we call a flow measure. It measures the difference between two numbers that represent money flowing into and out of the government over a particular time frame (in this case, a year). The total amount the government has borrowed in the past is the debt. That’s a stock measure, an accumulation of past flows (including a few years of surplus in the late 90s). Each year’s deficit (flow measure) gets added to the debt (stock measure) left over from past years. So the federal debt increased by about $642 billion last fiscal year because the U.S. government spent that much more than it collected. (Another caveat/complexity: [3])

Unfortunately it gets a little messy here. Most economists and budget wonks care about the total amount the U.S. federal government has borrowed from the rest of the world, including from American citizens, private firms and investment funds, foreigners and foreign governments, and anyone else who wants to buy Treasury debt. We call this total amount that the U.S. federal government owes to the rest of the world the debt held by the public, where “public” really means “everyone except for the U.S. federal government.” [4] As of last Thursday, debt held by the public was $11,937,127,964,522.94. If you ask me the size of the federal debt, I’d tell you almost $12 trillion. That’s how much the U.S. federal government currently owes everybody else.

The messiness arises because the U.S. federal government also issues debt to itself. Much of this intragovernmental debt is for Social Security. Treasury’s site shows us that intragovernmental debt is now about $4.8 trillion. This debt represents a promise from one part of the federal government to another. There’s a whole philosophical debate about how “real” this intragovernmental debt is and how it relates to the unfunded liabilities of the Social Security program, but we can ignore that debate here.

If we add these two numbers together, the $11.9 trillion debt held by the public and the $4.8 trillion intragovernmental debt, we label the sum total public debt. Total public debt at the end of last Thursday was about $16.7 trillion.

The debt limit, then (subject to yet another complexity/caveat [5]) applies to total public debt, both the amounts Treasury borrows from the rest of the world and the amounts the federal government borrows from/lends to itself.

What, then, is the debt limit? The President can only borrow cash from the rest of the world because Congress allows him to, and Congress doesn’t give him unlimited authority to borrow. A law limits the total amount of debt that can be issued (remember, including intragovernmental debt since the legislated limit is on total public debt and not on debt held by the public). Treasury is not legally allowed to issue more debt once total public debt has reached the limit specified in law. The debt limit is a legislated cap on the total public debt that Treasury can issue (skimming again over caveat [5]).

Remember that cash flows into and out of the government every day. The bad scenario that’s triggered by “bumping up against the debt limit” (or debt ceiling, which is the same thing) is that, because our government is spending more than it collects, and because it soon will not be allowed to borrow any more cash from the rest of the world, Treasury won’t have the cash it needs to pay somebody on time.

That’s it for the beginner lesson. You now have the basics of:

  • the unified budget deficit;
  • debt held by the public;
  • intragovernmental debt and total public debt;
  • and the debt limit.

And you understand that, if crunch time occurs, the inability to borrow is the intermediate problem, while the ultimate problem is a lack of sufficient cash to pay all the bills on time.

Now that we have built this foundation, we can look into the particulars of the current debt limit stalemate. Stay tuned.

[1] Flows of “cash” is an oversimplification.  Technically a lot of that money is flowing in the form of checks (you write a check to the IRS or the government writes a check to a Social Security recipient) or electronic transfers.

[2] There’s an exception to the idea of the deficit measuring the difference between two cash flows.  Government accounting rules say that the deficit effect of certain credit programs, like student loans, is measured in terms of present value rather than cash flows. This changes the numbers but not the concepts for this introduction, so I’m going to ignore it here.

[3] Because of government accounting conventions, there are some things which affect the debt without affecting the deficit. We’ll ignore those here. And the credit program caveat in [2] also has an effect here.

[4] Is the Federal Reserve part of the U.S. federal government? For this purpose, the best answer is “it depends.” Nothing in government accounting is easy. <sigh>

[5] A few “federal entities” like the Tennessee Valley Authority and Fannie Mae and Freddie Mac (now effectively owned by the government) can issue debt that gets counted as part of total public debt but isn’t part of that limited by the debt limit law. There are a couple of kinds of debt that count as total debt but not as debt subject to limit, including debt issued by the Federal Financing Bank and “Hope Bonds,” created in 2008.  This makes total public debt a bit bigger than debt subject to limit, and the latter is what is restricted by a debt limit law.