As of late October 11, 2013, nothing had yet occurred to
solve the problem of the debt ceiling.
So hysterical is the rhetoric that one may think bumping into the debt
ceiling comes around about as often as Haley’s Comet. In fact, the government has raised the debt
ceiling five times since 2001 typically without this much fanfare. What started all this? Is it a new
phenomenon? Why do we have a debt ceiling anyway? Let’s look at the history and then think
about the consequences to not allowing the debt ceiling to be raised next week.
The government raises tax revenue and spends money and there
are three possible outcomes from this.
Tax revenue can equal spending and we have a balanced budget. Tax revenue can exceed spending and we have a
surplus. Or, tax revenue can be less than spending and we a deficit. What does the government do when it has a
deficit? Up until recently my bet is
that most people would have said the government prints money. Not exactly.
There is not, thank God, a printing press in the basement of the Rayburn
office building or in the Oval office.
While only the congress has the power to tax and spend, the Federal
Reserve actually controls the money supply. So, if the government spends more
than it takes in it sells bonds, borrows money.
What it borrows per year is the deficit and the past accumulation of
borrowing is the debt. There is not a
deficit limit. There is no legislation
that states how much Congress can spend over its collection of taxes in a
year. There is, however, a debt limit. Total federal debt has been limited since the
Second Liberty Bond Act of 1917. The statutory limit was denominated in an
actual dollar amount and given that government runs deficits nearly every year,
it is no wonder we are constantly bumping against that limit.
When the debt ceiling was first established in 1917 it was
$11.5 billion. It has been raised 74
times since March 1962. The first time it was raised during the Reagan
administration in 1981, it went just over $1 trillion. The National Debt right now is just under $17
trillion. It is difficult to find a
source to say what the exact number of the debt ceiling is. Perhaps that is
because some of the debt is exempt from the ceiling and the calculation is not
all that easy. The magic date seems to
be October 17th. The US will
reach the maximum amount it can borrow and there will be no new bonds issued.
Why are we facing this crisis? There are really two questions there. The first is: why is there a debt ceiling and
the second is, why have we waited so long to address the issue?
When Congress passed a debt ceiling back in 1917 it was
trying to impose an external restraint on how much it could spend. It seemed comforting to know that we would
not borrow past a certain limit. The
party not in charge of the Congress can always point to reaching the debt
ceiling as a sign of the profligate spending by the group in power. A number of
times when the debt ceiling has been raised, it has been raised by a percentage
of the existing debt as opposed to a strict number. Who knows what will happen this time. We have come to this crisis point in part
because of a breakdown in civility in Washington and in part, because the debt
has really grown in recent years. As recently
as 2007 the debt was under $10 trillion but more importantly, it was about 65%
of GDP. The measure of the scale of the debt is not the absolute number, but
its relative size to, say, GDP. Now, it
is bumping up against 100% of GDP and people have become alarmed. Even though the deficit has fallen in recent
years, the debt to GDP ratio continues to grow and that is what is sounding the
alarm. We have waited this long to address the issue because Congress, like all
people, prefer to kick the can down the road.
In this particular instance, Congress has become the Sebastian
Janikowski[i]
of can kickers and there are threats that we will let the government reach its
limit and stop borrowing. What will
happen?
The big discussion seems to be about the US defaulting on its
bond obligations. In truth, that does
not have to happen. The US can roll over
the existing debt it has without surpassing the ceiling and it can pay the interest
on the debt. That said, what could
happen is not a pretty scenario. The US government spends about $3.5 trillion a
year and brings in $2.7 trillion in tax revenue. Thus, spending would have to be reduced by
$800 billion in order to balance the budget and not have to spend based on
issuing bonds. Some might think that an
$800 billion reduction in federal spending would be good. Without debating the long term consequences,
it would not be good in the short run.
In fact, it is such a large cut in spending that it would almost be
impossible to carry out. Even those who
might think that an $800 billion reduction in spending would be good would
complain as soon as their ox is getting gored.
However, the long term consequences of following our current path are
not something we want to see either.
What will happen? As
loathe as I am to forecast, we will come up with some short term deal and may
already have done so by the time you read this.
What one hopes this crisis brings about is a meaningful discussion of
the size of government and how it should be financed. There are many concerns about the debt, here
is my largest. Interest payments on the
debt come from tax revenue and that is how it should be. You don’t want to service your debt, whether
you’re a country or a firm, by borrowing every time interest payment comes
due. So, interest payments should be
made out of revenue which for the government means tax revenue. How much of that tax revenue will go toward
servicing the debt? Net interest on the
debt right now is about $330 billion per year or maybe 12% of tax revenue. We are currently financing our debt with some
of the lowest borrowing rates in history on Treasury bonds and bills. However, as the debt to GDP ratio continues
to rise, and once interest rates return to their historical levels, the
interest cost to service the debt will rise.
No one knows exactly how high because we don’t know what will happen to
interest rates. Some sources predict a
trebling of interest cost on the debt within the next three years. Of course
tax revenue will grow over that time but we could easily be looking at 25% of
tax revenue going just to service the debt. As that happens, our ability to do the kinds
of things we want to do with tax revenue is diminished. If 25% of your income is going to pay the
interest on your credit card debt, you have a reduced standard of living. That is, I think, the biggest long term
concern of the size of the debt relative to GDP.
Will we pass a temporary debt ceiling increase and kick this
can down the road? Yes. Is the debt ceiling an artifice to allow for
these discussions to move into crisis mode? Yes. But, do we need to address the long term
implications of the debt in a calm and meaningful way sometime soon? Absolutely
yes. Unfortunately, Congress acts too
much like a freshman with a term paper. We won’t get back to it until the next
crisis comes to a theatre near you.
[i]
NFL kicker – known as the Polish Cannon. Larry Davidson will be upset I used
this analogy instead of him as he kicked field goals in high school and college
football.
Thanks! This explanation was more clear than any I've read. They usually get clouded by all the ideological dust being kicked up. This one was very good! And I knew who Sebastian is without the footnote.
ReplyDelete