by Meg Handley

Some experts say it's unnecessary and has morphed into a political tool

Republicans and Democrats remain at loggerheads over raising the nation's debt ceiling as the clock ticks down to the August 2 deadline. With all the partisan infighting and investor angst the debate has generated, it might seem like the best thing politicians can do with the debt ceiling is get rid of it.

Even financial sage and former Fed chairman Alan Greenspan has suggested doing away with debt ceiling. "This is an unnecessary problem," he said of the impasse between Democrats and Republicans at the Aspen Ideas Festival in June. "The debt ceiling problem is synthetic and self-administered."

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The ceiling itself is unnecessary for managing the country's finances, and according to some critics, has become more of a symbolic political tool than a real mechanism for controlling debt. "It's redundant in that there's a budget process every year, and that essentially establishes the balance between expenditures and revenues and the amount that needs to be financed," says Sara Johnson, senior research director for global economics at IHS Global Insight.

The debt ceiling only relates to that last piece -- "the amount that needs to be financed" -- which the Treasury does by issuing bonds, and has little to do with reining in spending, tax hikes, or otherwise improving the country's financial situation. The fact that the budget (which determines the gap between expenditures and revenue that needs to be financed) and debt ceiling are voted on separately underscores the redundancy of the limit in some respects. "The debt limit, to some extent, is an artificial thing," says Reena Aggarwal, professor of finance at Georgetown University's McDonough School of Business.

Congress instituted the debt ceiling in 1917 to avoid having to approve each and every Treasury auction, but by turning what was once meant to expedite debt issuance into grounds for a political tug-of-war, Congress again finds itself in deadlock. Some have called the jostling between parties a "game of chicken," but experts say the stakes are high and the potential economic harm is very real.

At this point, no one knows exactly what will happen if Congress fails to increase the debt ceiling, but the bottom line is that the Treasury Department would not be able to borrow any more money. That's a problem because the government borrows money by issuing bonds to bridge the shortfall between revenue and expenses. The government would have to stop, limit, or delay payments on outstanding debt obligations, something Treasury Secretary Timothy Geithner has warned would have "catastrophic economic consequences."

Default by the U.S. government could plunge the country into another financial crisis, resulting in "the loss of millions of American jobs," according to the Treasury, and jeopardize the government's reputation as a credible borrower. The U.S. government has enjoyed a relatively unchallenged position as a safe haven among bond investors, but uncertainty about its finances could translate into higher borrowing costs. That would mean more taxpayer dollars would have to go toward debt service instead toward social services and other government programs.

But for all the criticism hurled at the debt ceiling, it may still have some value in keeping the government accountable for its expenditures, some experts argue. "[You could say] that it does force politicians to periodically go back and ask themselves some hard questions about the fiscal health of the U.S.," says Russ Koesterich, iShares global chief investment strategist and author of The Ten Trillion Dollar Gamble.

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A quick survey of the financial situations in developed countries paints a sobering picture of the scourge of unrestricted borrowing. Much of southern Europe teeters on the edge of default; Britain and Belgium, too, grapple with soaring public debt. Developing countries such as Argentina and Brazil have also had problems controlling debt in the past.

"I'm not opposed to the idea of having a debt ceiling," says Adolfo Laurenti, deputy chief economist at Chicago-based financial services firm Mesirow Financial. "In general, one problem that most countries have around the world is that the spending power of the government is, for the most part, unchecked and that really allows some governments to spend exorbitant amounts of money and get themselves in trouble."

While the United States might benefit from having some benchmark for debt issuance, the current incarnation of the debt ceiling rule is less than ideal. "The debt ceiling is not a very smart rule because it's in nominal terms," Laurenti says. "Because the size of the economy keeps growing so spending is growing, we've had to go through this painful exercise of raising the debt ceiling with a certain frequency."

A system based on debt as a percent of GDP would be better, Laurenti says, and should include the flexibility to issue more debt during recessions or other financial emergencies. "Ideally you would want to have something on a constitutional level," he says, emphasizing the need for a long-term rather than short-term solution for the debt problem. "When you make the rules out of a normal Congressional procedure, then in two years you might have a new majority that will change everything."

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Eventually, Congress must raise the debt ceiling -- not doing so would be economic suicide, experts say, with far-reaching impacts not only at home but abroad as well. Until August 2, the Treasury can continue "shuffling paper" to meet the country's financial obligations, but past that date, the details start to become foggy. The Treasury will have to prioritize payments, which could mean suspending Social Security payments or even delaying interest payments to bondholders, an event that would likely send global markets reeling.

That's the worst-case scenario. Most experts say an agreement will be made ahead of the August deadline, but the bottom line is that squabbling over the debt ceiling is distracting Congress from dealing with the fundamental issues at the core of the country's debt problem. Until those are resolved, structural problems with spending, revenue, and debt will continue cropping up and over time could degrade America's reputation among investors as a fiscally responsible country.

"At the end of the day, what matters is our fiscal house and how we are managing it," Aggarwal says. "We've had such drama going on and the negative side is it creates so much uncertainty in the marketplace, and the financial markets hate uncertainty. The underlying issues have to be addressed. We really need to think about getting our deficit down."


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