The Debt Ceiling

As expected the US Congress and the President came to some sort of arrangement to ensure that the US does not default on its debt obligations. No one, however, seems to be satisfied. The only feasible political solution involves a balance of spending cuts and tax increases. Obama has it right on this. But the correct economic solution at the moment is not to cut spending at a time of economic stagnation. A better economic solution would be to raise taxes on those who can most afford it and are unlikely to curb their spending habits if their after tax income is reduced slightly i.e. the rich!

Generally it has been Republican presidents that have been the biggest spenders, rather than so-called "tax and spend" Democrats. See here for an analysis.  

If you're looking for a primer on the crisis, this from the NYT is pretty good.

Some of the important bits from the NYT article.

Q. Republicans and Democrats alike keep talking about the need to reduce the federal deficit. Won’t refusing to raise the debt limit cut the deficit?

A. No. The debt limit, or ceiling, which is the amount that the nation is allowed to borrow, must be raised if the United States is to pay for all the things that Congress has already bought: the spending in the budget bills it has already passed, the Social Security checks promised to retirees, the payments due to private companies with federal contracts and the interest on bonds it has sold. Washington has long spent more money than it takes in, and planned to make up the difference with borrowing. Both parties agree that this cannot go on forever. But if the debt limit is not raised, it will not cut the nation’s deficit or allow the government to get out of its existing obligations. It will simply make it impossible to borrow the money that the government needs to pay for them.

... “While debates surrounding the debt limit may raise awareness about the federal government’s current debt trajectory and may also provide Congress with an opportunity to debate the fiscal policy decisions driving that trajectory, the ability to have an immediate effect on debt levels is limited,” the Government Accountability Office reported. “This is because the debt reflects previously enacted tax and spending policies.”

Q. This sounds like an odd system. Do you mean that Congress can pass a budget that requires borrowing, and then argue later about whether to approve that borrowing?

A. That’s right. The system goes back to World War I, when Congress first put a limit on federal debt. The limit was part of a law that allowed the Treasury to issue Liberty Bonds to help pay for the war. The law was intended to give the Treasury greater discretion over borrowing by eliminating the need for Congress to approve each new issuance of debt. Over the years the limit has been raised repeatedly, to $14.3 trillion today from roughly $43 billion in 1940. Of the $14.3 trillion, $4.6 trillion is held by other government accounts, like Social Security trust funds. Outside observers have noted that the failure to make increases in the debt limit part of the regular budget process can be risky. The G.A.O. concluded that it would be better if “decisions about the debt level occur in conjunction with spending and revenue decisions as opposed to the after-the-fact approach now used,” adding that doing so “would help avoid the uncertainty and disruptions that occur during debates on the debt limit today.”

Q. So what happens to government spending if the debt limit is not raised? Will the United States default?
A. The United States will not have enough money to pay all of its bills. The country technically hit the debt ceiling in May, but it instituted a series of temporary measures to avoid having to raise the limit that the Treasury estimates will run out around Aug. 2. So what does that mean? The United States will owe about $307 billion during the rest of August, but it is expecting to take in about $172 billion in revenues, according to an analysis by the Bipartisan Policy Center. Without enough money to pay all of its bills, the government will have to decide what to do. The possibilities range from “prioritizing” some payments and paying them first to paying bills in the order in which they were received.

The Bipartisan Policy Center analysis notes that if the government were to choose to pay the interest on its debt, Social Security benefits, Medicaid and Medicare payments, defense contractors and unemployment benefits, it could not have enough left to pay for the salaries of federal workers and members of the military, Pell grants for college, highway construction or tax refunds, among other things. Some analysts argue that as long as the nation continues making its payments on the national debt, it will not be in default. The Treasury disputes that, arguing that “adopting a policy that payments to investors should take precedence over other U.S. legal obligations would merely be default by another name, since the world would recognize it as a failure by the United States to stand behind its commitments.”

Q. What could a default mean for the economy?

A. It could be bad, on several levels. A default is typically a decision not to pay government bondholders back, in part or in full, but the rating agencies have said they might consider the United States in default if it fails to pay other creditors like government vendors. If the federal government interrupts payments, whether to Social Security recipients or contractors, those people will then have less money to spend, and the economy will slow down. And if the United States defaults on its debt, there is a risk that the investors could demand a higher interest rate. Then, consumers could also feel the pinch: because the interest rates paid by corporations and consumers in the United States are tied to the rate the nation pays, interest rates could go up for everything from credit cards to mortgages. A homeowner with a mortgage for $100,000 might see her annual mortgage costs go up by $100 to $200 a year, economists say.

So the failure to raise the debt limit could slow the nation’s recovery, Ben S. Bernanke, the chairman of the Federal Reserve, warned in a speech last month. “Failing to raise the debt limit would require the federal government to delay or renege on payments for obligations already entered into,” he said. “In particular, even a short suspension of payments on principal or interest on the Treasury’s debt obligations could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of U.S. government debt, create fundamental doubts about the creditworthiness of the United States and damage the special role of the dollar and Treasury securities in global markets in the longer term. Interest rates would likely rise, slowing the recovery and, perversely, worsening the deficit problem by increasing required interest payments on the debt for what might well be a protracted period.”

...

Q. What about the rest of the world? Will other countries continue to invest in the United States? Would a default send investors to the safety of other currencies?

A. There are already indications that this is beginning to happen. Switzerland’s franc strengthened to a record high against the dollar this week, as concern about the debt limit in the United States and worries about the euro, given the Greek crisis, sent investors looking for safety. Some bond funds are already moving to invest in bonds from Canada, Mexico and China. And there are concerns about what would happen if America’s foreign creditors, led by China, were to try to dump some of their American debt. In the last decade, foreign money has poured into the United States, creating so much demand for Treasury bills that it has kept the United States’ interest rate low. This month, the authorities in Beijing expressed concern about the debt standoff in the United States. “We hope that the U.S. government adopts responsible policies and measures to guarantee the interests of investors,” said Hong Lei, a Foreign Ministry spokesman.

Q. How many times has the debt ceiling been raised, and by whom?

A. It has been a bipartisan exercise. By the Treasury Department’s count, Congress has acted 78 times since 1960 to raise, extend or alter the definition of the debt limit — 49 times under Republican presidents, and 29 times under Democratic presidents. The Obama administration has taken pains to note that President Ronald Reagan, a hero to many Republicans in Congress, raised the debt limit. In a letter on the debt ceiling last month to Republicans in the Senate, Treasury Secretary Timothy F. Geithner quoted a letter Mr. Reagan wrote a generation ago, urging Congress to increase the debt limit. “The full consequences of a default — or even the serious prospect of default — by the United States are impossible to predict and awesome to contemplate,” he quoted Mr. Reagan as writing. “Denigration of the full faith and credit of the United States would have substantial effects on the domestic financial markets and on the value of the dollar in exchange markets. The Nation can ill afford to allow such a result.”

Q. How has the debt risen this high, and how much are we paying in interest as a nation?

A. The United States has not always operated with such a large debt. After financing World War II with substantial borrowing, the outstanding debt held pretty stable for the next 25 years, going up to $283 billion in 1970 from $242 billion in 1946. But over the last 30 years, the overall debt has increased under every president — with the biggest increase under President George W. Bush, who cut taxes, added a drug benefit to Medicare and fought two wars. As the debt has grown, so have the country’s interest payments. In 2003, for instance, the government paid about $150 billion in interest costs; this year it is estimated to be upward of $200 billion. These interest payments are taking up more federal spending now than federal outlays on education, transportation and housing and urban development combined. Though the interest costs are substantial, they have remained lower than some economists predicted because the world has continued to lend money to the United States at very low interest rates, even as the nation’s debt has grown.

Q. Has what is going on in Washington already hurt the economy and the reputation of the United States in financial markets around the world?
A. Stocks fell steeply on Wednesday on worries that the United States could default or see its credit rating cut, and Treasury market analysts and traders are already saying that the credibility of the United States has been damaged. Mark Zandi, the chief economist of Moody’s Analytics, said last week: “Our aura is diminished. You know people really view the U.S. as the AAA, the gold standard, and I think we’re tarnishing that.” Treasury bonds have always been considered to be virtually risk-free, and that is why many investors — in the United States and abroad — hold them and many companies use them to back up other investments. If their security is questioned, investors may shift away from them. The caveat, though, is that there are few safe places today for investors to put their cash. So some traders say that investors may see few alternatives, and opt to stay put.

Q. Has the United States defaulted on its debt before?

A. Technically, yes. In 1979, as Congress was considering raising the debt limit, negotiations ran down to the wire. The Treasury Department had what it called technological glitches, and it was late paying a relatively small number of its Treasury notes. This amounted to a technical default, not a permanent one, because the note holders were eventually paid in full. Some finance professors who have studied the incident say it led to higher interest rates.

See also this from the NYT