Partying Like It's 1995

"Pressure grew on Republicans to accept an increase in the nation's debt ceiling yesterday when a major Wall Street rating firm threatened to downgrade U.S. government securities," read one article.

"We need to know what options are available to avoid default," remarked a worried congressman.

"The Treasury Department said it was [its] 'duty and intention to take all legal steps necessary to assure that the nation's financial obligations -- obligations already approved by Congress -- are honored,'" reported The New York Times.

"Default would produce global economic and financial crisis of major proportions," warned the Treasury secretary. 

What's interesting about these quotes? They're all from 1995.

Yes, we've been here before. Dig through news archives long enough, and you come to that conclusion over and over again. As fellow Fool Alex Dumortier astutely noted yesterday, "Virtually everything we consider to be unprecedented has already been experienced."

The debt ceiling was, of course, raised in early 1996, avoiding a default on Treasury securities that would have no doubt ushered in a financial crisis.

Odds are our current situation will end the same way. Business Insider asked a gaggle of Wall Street investors if they were worried about a looming default. Virtually all said no. The ceiling will be raised, and everyone knows it. This is posturing and nothing else -- just as it was in 1996.

But what if? Raising the ceiling today is a who-will-blink first standoff between two parties, both vowing they won't budge from their demands until the other side's demands are dropped. The odds that something atrocious could happen are small, but uncomfortably present.

Enough ink has been spilled analyzing what might happen if the Treasury does default. The answer is: nothing good. Interest rates would surge. Money market funds would likely collapse. The biggest banks, including everyone from Wells Fargo (NYSE: WFC  ) to Bank of America (NYSE: BAC  ) to American Express (NYSE: AXP  ) , who either hold or are tied to counterparties who hold Treasury debt would get a taste of 2008 deja vu.

Rather than dwell on that nightmare, let's ask a simple question: Why do we have a debt ceiling?

Every year, Congress gets together and votes on rates of spending and taxation. They agree on a plan, which becomes the budget. The budget lays out how much will be spent, and at what level income will be taxed.

Unique to the United States, Congress then engages in a separate vote deciding on whether to pay for said budget by allowing an appropriate amount of debt to be issued. That's an important -- and ludicrous -- aspect that often goes misunderstood: Raising the debt ceiling is not a matter of preventing future deficits. It's quite literally Congress debating whether it wants to pay for the bills Congress has already passed. As the nonpartisan Congressional Budget Office notes:

By itself, setting a limit on the debt is an ineffective means of controlling deficits because the decisions that necessitate borrowing are made through other legislative actions. By the time an increase in the debt ceiling comes up for approval, it is too late to avoid paying the government's pending bills without incurring serious negative consequences.

The current form of the debt ceiling began in 1939 as a good-faith idea that it would actually curtail deficits. World War II necessitated deficits, prompting the ceiling to be raised. Ever since getting a taste of a simple vote overriding its handcuffs, there's been no looking back: Congress has raised the ceiling 87 times since 1945, or an average of every nine months.

The debt ceiling would work if pre-agreed-upon budgets had to fall within debt limit constraints, and if the ceiling could not be raised. But they don't, and it can, making it utterly useless. And not just useless, but dangerous. The odds that Congress will voluntarily default on our national debt are small, but there.

Once this is all over, the conversation shouldn't be over when the ceiling will be raised again. It should be why we have one at all.

What do you think?

Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. The Fool owns shares of and has opened a short position on Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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