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Is the economy heading toward another cataclysm? According to Treasury Secretary Timothy Geithner, the federal government will bump against the current $14.29 trillion debt ceiling by May 16, if Congress does not take prompt action.

If the ceiling is not pushed up immediately, the country will default on its obligations. As a result, both American and foreign investors will lose confidence in the country’s ability to meet commitments. As of Friday, the government's debt remained just $95 billion below the ceiling.

We understand that government spending in the form of several stimuli was a prerequisite to stabilize the financial system. However, these initiatives should not have been taken at the cost of mounting national debt. The government should have taken additional policy measures to control spending and resist deterioration in budget deficit.

According to Geithner, cutting expenditures will not be sufficient to avoid hitting the debt ceiling. He also said that selling financial investments, gold and student loans would not be feasible for the country.

The Core of the Matter

What is the debt ceiling? It is an upper limit on the amount of debt federal government can borrow to operate economic activities of the country. A law for debt ceilings was passed by Congress in 1917 to simplify access to funding.

The primary purpose of setting the debt ceiling is accounting assessments, required to control the budget deficit. Based on policies and related costs, the government settles on the amount it needs to borrow for a given period. Accordingly, it sets the debt limit, which theoretically keeps spending in check.

According to the Congressional Research Service, the debt ceiling has been raised 74 times since March 1962. The ceiling was last set at $14.3 trillion in February 2010.

What Could Possibly Ensue?

If the U.S. hits the debt ceiling, it would be precluded from borrowing any more funds. Then, the country, which is already neck-deep in loans, would be in a fix. Funding its operations and paying creditors would become unfeasible. The ramification of lapsing loan obligations would then malign the domestic environment and spread the condition internationally.

Almost all the listed U.S. companies, including major banks like JPMorgan Chase & Co. (NYSE:JPM), The Goldman Sachs Group Inc. (NYSE:GS), Morgan Stanley (NYSE:MS), Citigroup Inc. (NYSE:C) and Bank of America Corporation (NYSE:BAC) would lose access to markets and investors if the country touches its debt ceiling.

Additionally, this would pull down America's credit rating, making it difficult for the country to continue borrowing money from other nations. America would face a serious debt crisis, perhaps akin to Greece, Mexico and Argentina -- countries that are still struggling to even out.

What If Delayed?

Though the Treasury might succeed in pushing back the date of the catastrophe through some extraordinary actions, it will not get more than eight weeks of additional time to make long-term borrowing arrangements, according to Geithner. The postponed date would be sometime around July 8.

The actions could include suspending sales of government securities, plummeting some pension funds and accessing the exchange stabilization fund. These actions can save about $230 billion, Geithner said. Though these actions will help the Treasury to buy some more time, the upshot will not change.

Is This All About Politics?

The entire debt ceiling episode is nothing but a political play. While some Republican lawmakers are against raising the debt ceiling before dealing with government spending, others recognize the need to let the government to act otherwise. Though Republicans won control over the House of Representatives in November 2010, with a promise to address the debt issue and cut government spending, it looks like the majority party might now compromise on the debt front.

It’s now a "catch-22" situation for the Obama administration. While it knows that hitting the debt limit would be disastrous for the economy, it is not able to implement a spending cut fearing disruptions in economic recovery.

Political parties can fiddle with the issue as per their wishes. If a party wants to keep the issue alive, it will give the ceiling a slight nudge so that the question surfaces soon. Adversely, there will be a big push in case a party wants to avoid the debate for a long time.

Is the Course of Action Fixed?

It is almost certain that Congress will read the warning and raise the debt ceiling prior to knocking it. If we are to go by past records, this should tidy up the economic mess related to the debt issue for the next few years.

However, in order to gain Republican support, the government will have to figure out some spending cuts, which will again moderate the efficacy of its stimulus packages.

To Be Continued

Raising the ceiling is not new or unusual. Rather, this has become a myopic Congressional drill to keep the government afloat. However, considering that the government debt is independent of other fiscal policy measures, there will probably be no long-term solution to the debt issue. Without balancing fiscal policy measures, the demand for raising the debt ceiling will automatically increase.

Though we don’t know how high the ceiling can be, increasing it will definitely help the government to continue borrowing. But it will raise concerns related to debt escalation instead of providing a debt solution. Instead, greater efforts to pay down the debt or spending less would be a more feasible way out.

Source: U.S. to Hit Debt Ceiling Soon