What Is the 2011 U.S. Debt Ceiling Crisis?

The 2011 U.S. Debt Ceiling Crisis was a contentious debate in Congress that occurred in July 2011 regarding the maximum amount of debt the federal government should be allowed.

Understanding the 2011 U.S. Debt Ceiling Crisis

The federal government has rarely achieved a balanced budget, and its budget deficit ballooned following the 2007-08 Financial Crisis. In the 2008 fiscal year, the deficit stood at $458.6 billon, widening to $1.4 trillion in 2009 as the government engaged in a massive fiscal policy response to the economic downturn.

Between 2008 and 2010, Congress raised the debt ceiling from $10.6 trillion to $14.3 trillion. In 2011, as the economy showed early signs of recovery and federal debt approached its limit once again, negotiations began in Congress to balance spending priorities against the ever-rising debt burden. 

Heated debate ensued, pitting proponents of spending and debt against fiscal conservatives. Pro-debt politicians argued that failing to raise the limit would require immediate cuts to spending already authorized by Congress, which could result in late, partial, or missed payments to Social Security and Medicare recipients, government employees, and government contractors.

Moreover, they asserted the Treasury could suspend interest payments on existing debt rather than withhold funds committed to federal programs. The prospect of cutting back on already promised spending was labeled a crisis by debt proponents.

On the other hand, the specter of a technical default on existing Treasury debt roiled financial markets. Fiscal conservatives argued that any debt limit increase should come with constraints on the growth of federal spending and debt accumulation.

Outcome of the 2011 U.S. Debt Ceiling Crisis

Congress resolved the debt ceiling crisis by passing the Budget Control Act of 2011, which became law on August 2, 2011. This act allowed the debt ceiling to be raised by $2.4 trillion in two phases, or installments.

In the first phase, a $400 billion increase would occur immediately, followed by another $500 billion unless Congress disapproved it. The second phase allowed for an increase between $1.2 trillion and $1.5 trillion, subject to Congressional disapproval as well. In return, the act included $900 billion in slowdowns in planned spending increases over a 10-year period. It also established a special committee charged with finding at least $1.5 trillion in additional savings.

In effect, the legislation incrementally raised the debt ceiling from $14.3 trillion to $16.4 trillion by January 27, 2012.

Following the passage of the act, Standard & Poor’s took the radical step of downgrading the United States long-term credit rating from AAA to AA+, even though the U.S. did not default. The report says, “The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.” The credit rating agency cited the unimpressive size of deficit reduction plans relative to the likely future prospects for politically driven spending and debt accumulation.

Debt Approval Process Leading to the 2011 U.S. Debt Ceiling Crisis

The U.S. Constitution gives Congress the power to borrow money. Before 1917, this power was exercised by Congress authorizing the Treasury to borrow specified amounts of debt to fund limited expenses, such as war-time military spending, which would be repaid after the end of hostilities. This kept the national debt directly linked to authorized spending.

In 1917, Congress imposed a limit on federal debt as well as individual issuance limits. In 1939, Congress gave the Treasury more flexibility in how it managed the overall structure of federal debt, giving it an aggregate limit. However, by delegating debt management authority to the Treasury, Congress was able to break the direct connection between authorized spending and the debt that finances it. 

While allowing greater flexibility to raise spending, this practice also created a need for Congress to repeatedly raise the debt limit when spending threatens to overrun available credit. Due to occasional political resistance to the idea of continually expanding the federal debt, this process of raising the debt limit has at times engendered controversy, which occurred during the 2011 Debt Ceiling Crisis.

The Bottom Line

Following the 2007-08 Financial Crisis, in an effort to slow down the severe recession as well as the persistently high unemployment rate, the government increased federal spending. As a result, the federal debt reached its limit on multiple occasions from 2008 to 2011 which led to a series of increases of the debt limit. In 2011, the Treasury asked for its borrowing capacity to be extended.

The 2011 U.S. Debt Ceiling Crisis was a contentious debate in Congress that occurred in July 2011 regarding the maximum amount of debt the federal government should be allowed. Congress resolved the debt ceiling crisis by passing the Budget Control Act of 2011, which became law on August 2, 2011. This act allowed the debt ceiling to be raised by $2.4 trillion in two phases, or installments.

What Is the 25% Rule?

There are two common usages of the term “25% rule”:

1. The 25% rule is the concept that a local government’s long-term debt should not exceed 25% of its annual budget. Any debt beyond this threshold is considered excessive and poses a potential risk, as the municipality may have trouble servicing the debt.
2. The 25% rule also refers to a technique for determining royalties, which stipulates that a party selling a product or service based on another party’s intellectual property must pay that party a royalty of 25% of the gross profit made from the sale, before taxes. The 25% rule also commonly applies to trademarks, copyrights, patents, and other forms of intellectual property.

Understanding the 25% Rule

In both uses of the term, the 25% rule is more a matter of customary practice or heuristic (i.e., a rule of thumb), rather than an absolute or optimal threshold, or a strict legal requirement.

In the public finance setting, the 25% rule is a rough guideline for fiscal planning based on the confidence of bondholders and credit rating agencies. In the intellectual property arena, the 25% rule evolved from the customary rates negotiated between intellectual property holders and licensees.

25% Rule for Municipal Debt

Local or state governments looking to fund projects through municipal bond issues have to make assumptions about the revenues they expect to bring in, often through taxation or projects like toll roads, which in turn will allow them to support bond payments. If revenue falls short of expectations, those municipalities may not be able to make bond payments, which can cause them to default on their obligations and hurt their credit rating.

Municipal bondholders want to make sure that the issuing authority has the capacity to pay, which can be jeopardized by getting too deep in debt. Bondholders are thus cautious about purchasing bonds from local or state governments that are in violation of the 25% rule.

Tax-exempt private activity bonds—bonds issued by municipalities on behalf of private or non-profit organizations—also have a 25% rule applied to the proceeds from the bonds. This rule states that no more than 25% of bond proceeds may be used for land acquisition.

25% Rule for Intellectual Property

Patent or trademark owners use the 25% rule as a yardstick for defining a reasonable amount of royalty payments. The rule assumes that a licensee should retain at most 75% of the profits of a patented product given that s/he took on the bulk of the risks of developing the product and bringing the intellectual property to the market. The patent owner takes the remainder as a license royalty.

Setting the value of intellectual property is a complex matter. Although royalties are typically assessed against revenues, the 25% rule applies to profits. Furthermore, the 25% rule does not closely define what “gross profit” includes, which creates ambiguity in the valuation calculation. Because it’s a simple rule, it does not take into account the costs associated with marketing the product. For example, the holder of a copyright will receive a 25% royalty, though the party doing the selling usually incurs the cost of attracting demand in the market through advertising.

In the 2011 court case of Uniloc USA, Inc. v. Microsoft Corp, the court of appeals for the Federal Circuit ruled that the 25 percent rule may not be used as a starting point for a patent damage analysis bound for the courtroom. The appeals court concluded that the rule does not rise to an admissible level of evidence and may not be relied upon in a patent lawsuit in federal court. While the 25% rule may still be used by other parties in estimating a proposed patent royalty, it should not be considered a legal mandate.

What Is Austerity?

The term austerity refers to a set of economic policies that a government implements in order to control public sector debt. Governments put austerity measures in place when their public debt is so large that the risk of default or the inability to service the required payments on its obligations becomes a real possibility.

In short, austerity helps bring financial health back to governments. Default risk can spiral out of control quickly and, as an individual, company, or country slips further into debt, lenders will charge a higher rate of return for future loans, making it more difficult for the borrower to raise capital.

How Austerity Works

Governments experience financial instability when their debt outweighs the amount of revenue they receive, resulting in large budget deficits. Debt levels generally increase when government spending increases. As mentioned above, this means that there is a greater chance that federal governments can default on their debts. Creditors, in turn, demand higher interest to avoid the risk of default on these debts. In order to satisfy their creditors and control their debt levels, they may have to take certain measures.

Austerity only takes place when this gap—between government receipts and government expenditures—shrinks. This situation occurs when governments spend too much or when they take on too much debt. As such, a government may need to consider austerity measures when it owes more money to its creditors than it receives in revenues. Implementing these measures helps put confidence back into the economy while helping restore some semblance of balance to government budgets.

Austerity measures indicate that governments are willing to take steps to bring some degree of financial health back to their budgets. As a result, creditors may be willing to lower interest rates on debt when austerity measures are in place. But there may be certain conditions on these moves.

For instance, interest rates on Greek debt fell following its first bailout. However, the gains were limited to the government having decreased interest rate expenses. Although the private sector was unable to benefit, the major beneficiaries of lower rates are large corporations. Consumers benefited only marginally from lower rates, but the lack of sustainable economic growth kept borrowing at depressed levels despite the lower rates.

Special Considerations

A reduction in government spending doesn’t simply equate to austerity. In fact, governments may need to implement these measures during certain cycles of the economy.

For example, the global economic downturn that began in 2008 left many governments with reduced tax revenues and exposed what some believed were unsustainable spending levels. Several European countries, including the United Kingdom, Greece, and Spain, turned to austerity as a way to alleviate budget concerns.

Austerity became almost imperative during the global recession in Europe, where eurozone members didn’t have the ability to address mounting debts by printing their own currency. Thus, as their default risk increased, creditors put pressure on certain European countries to aggressively tackle spending.

Types of Austerity

Broadly speaking, there are three primary types of austerity measures:

• Generating revenue generation through higher taxes. This method often supports more government spending. The goal is to stimulate growth with spending and capturing benefits through taxation.
• The Angela Merkel model. Named after the German chancellor, this measure focuses on raising taxes while cutting nonessential government functions.
• Lower taxes and lower government spending. This is the preferred method of free-market advocates.

Taxes

There is some disagreement among economists about the effect of tax policy on the government budget. Former Ronald Reagan adviser Arthur Laffer famously argued that strategically cutting taxes would spur economic activity, paradoxically leading to more revenue.

Still, most economists and policy analysts agree that raising taxes will raise revenues. This was the tactic that many European countries took. For example, Greece increased value-added tax (VAT) rates to 23% in 2010. The government raised income tax rates on upper-income scales, along with adding new property taxes.

Reducing Government Spending

The opposite austerity measure is reducing government spending. Most consider this to be a more efficient means of reducing the deficit. New taxes mean new revenue for politicians, who are inclined to spend it on constituents.

Spending takes many forms, including grants, subsidies, wealth redistribution, entitlement programs, paying for government services, providing for the national defense, benefits to government employees, and foreign aid. Any reduction in spending is a de facto austerity measure.

At its simplest, an austerity program that is usually enacted by legislation may include one or more of the following measures:

• A cut or a freeze—without raises—of government salaries and benefits
• A freeze on government hiring and layoffs of government workers
• A reduction or elimination of government services, temporarily or permanently
• Government pension cuts and pension reform
• Interest on newly issued government securities may be cut, making these investments less attractive to investors, but reducing government interest obligations
• Cuts to previously planned government spending programs such as infrastructure construction and repair, health care, and veterans’ benefits
• An increase in taxes, including income, corporate, property, sales, and capital gains taxes
• A reduction or increase in the money supply and interest rates by the Federal Reserve as circumstances dictate to resolve the crisis.
• Rationing of critical commodities, travel restrictions, price freezes, and other economic controls, particularly in times of war

Criticism of Austerity

The effectiveness of austerity remains a matter of sharp debate. While supporters argue that massive deficits can suffocate the broader economy, thereby limiting tax revenue, opponents believe that government programs are the only way to make up for reduced personal consumption during a recession. Cutting government spending, many believe, leads to large-scale unemployment. Robust public sector spending, they suggest, reduces unemployment and therefore increases the number of income-tax payers. 

Economists such as John Maynard Keynes, a British thinker who fathered the school of Keynesian economics, believe that it is the role of governments to increase spending during a recession to replace falling private demand. The logic is that if demand is not propped up and stabilized by the government, unemployment will continue to rise and the economic recession will be prolonged.

But austerity runs contradictory to certain schools of economic thought that have been prominent since the Great Depression. In an economic downturn, falling private income reduces the amount of tax revenue that a government generates. Likewise, government coffers fill up with tax revenue during an economic boom. The irony is that public expenditures, such as unemployment benefits, are needed more during a recession than a boom.

Examples of Austerity

United States

Perhaps the most successful model of austerity, at least in response to a recession, occurred in the United States between 1920 and 1921. The unemployment rate in the U.S. economy jumped from 4% to almost 12%. Real gross national product (GNP) declined almost 20%—greater than any single year during the Great Depression or Great Recession.

President Warren G. Harding responded by cutting the federal budget by almost 50%. Tax rates were reduced for all income groups, and the debt dropped by more than 30%. In a speech in 1920, Harding declared that his administration “will attempt intelligent and courageous deflation, and strike at government borrowing…[and] will attack high cost of government with every energy and facility.”

Greece

In exchange for bailouts, the EU and European Central Bank (ECB) embarked on an austerity program that sought to bring Greece’s finances under control. The program cut public spending and increased taxes often at the expense of Greece’s public workers and was very unpopular. Greece’s deficit has dramatically decreased, but the country’s austerity program has been a disaster in terms of healing the economy.

Mainly, austerity measures have failed to improve the financial situation in Greece because the country is struggling with a lack of aggregate demand. It is inevitable that aggregate demand declines with austerity. Structurally, Greece is a country of small businesses rather than large corporations, so it benefits less from the principles of austerity, such as lower interest rates. These small companies do not benefit from a weakened currency, as they are unable to become exporters.

While most of the world followed the financial crisis in 2008 with years of lackluster growth and rising asset prices, Greece has been mired in its own depression. Greece’s gross domestic product (GDP) in 2010 was $299.36 billion. In 2014, its GDP was $235.57 billion according to the United Nations. This is staggering destruction in the country’s economic fortunes, akin to the Great Depression in the United States in the 1930s.

Greece’s problems began following the Great Recession, as the country was spending too much money relative to tax collection. As the country’s finances spiraled out of control and interest rates on sovereign debt exploded higher, the country was forced to seek bailouts or default on its debt. Default carried the risk of a full-blown financial crisis with a complete collapse of the banking system. It would also be likely to lead to an exit from the euro and the European Union.

What Is an Allowance for Bad Debt?

An allowance for bad debt is a valuation account used to estimate the amount of a firm’s receivables that may ultimately be uncollectible. It is also known as an allowance for doubtful accounts. When a borrower defaults on a loan, the allowance for bad debt account and the loan receivable balance are both reduced for the book value of the loan.

How an Allowance for Bad Debt Works

Lenders use an allowance for bad debt because the face value of a firm’s total accounts receivable is not the actual balance that is ultimately collected. Ultimately, a portion of the receivables will not be paid. When a customer never pays the principal or interest amount due on a receivable, the business must eventually write it off entirely.

Methods of Estimating an Allowance for Bad Debt

There are two primary ways to calculate the allowance for bad debt. One method is based on sales, while the other is based on accounts receivable.

Sales Method

The sales method estimates the bad debt allowance as a percentage of credit sales as they occur. Suppose that a firm makes $1,000,000 in credit sales but knows from experience that 1.5% never pay. Then, the sales method estimate of the allowance for bad debt would be $15,000.

Accounts Receivable Method

The accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts. The basic idea is that the longer a debt goes unpaid, the more likely it is that the debt will never pay. In this case, perhaps only 1% of initial sales would be added to the allowance for bad debt.

However, 10% of receivables that had not paid after 30 days might be added to the allowance for bad debt. After 90 days, it could rise to 50%. Finally, the debts might be written off after one year.

Requirements for an Allowance for Bad Debt

According to generally accepted accounting principles (GAAP), the main requirement for an allowance for bad debt is that it accurately reflects the firm’s collections history. If $2,100 out of $100,000 in credit sales did not pay last year, then 2.1% is a suitable sales method estimate of the allowance for bad debt this year. This estimation process is easy when the firm has been operating for a few years. New businesses must use industry averages, rules of thumb, or numbers from another business.

Default Considerations

When a lender confirms that a specific loan balance is in default, the company reduces the allowance for doubtful accounts balance. It also reduces the loan receivable balance, because the loan default is no longer simply part of a bad debt estimate.

Adjustment Considerations

The allowance for bad debt always reflects the current balance of loans that are expected to default, and the balance is adjusted over time to show that balance. Suppose that a lender estimates $2 million of the loan balance is at risk of default, and the allowance account already has a $1 million balance. Then, the adjusting entry to bad debt expense and the increase to the allowance account is an additional $1 million.