Why Debt Ceiling Matters

Posted on Thursday, 21st July 2011 @ 02:17 AM by Text Size A | A | A

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It appears that we are making progress in crafting an agreement for Congress to raise the debt ceiling from its current level of $14.3 trillion.  Since reaching that level on May 16th, the U.S. Treasury was unable to issue bonds to meet spending obligations.  However, it is Republican leadership’s goal to tie any increase in the debt limit to spending cuts.  Even before the spending binge during the early stages of the Obama administration to deal with the financial crisis, deficits have long been projected to unsustainable in the near future.

An aging population will be very costly to the U.S. economy.  First, the Baby Boomers are starting to retire and draw on Social Security.  Since the Baby Boomers represent a large portion of the U.S. population, there is concern that the Social Security Trust Fund will not be sustainable without significant changes or more dedicated financial support from Congress.  Second, retirees are more likely to use health care, so this is forcing pressure on private health care insurance companies to raise their premiums in order to remain profitable.  Even though it is hoped that new health care reform can mitigate these cost increases through a health mandate, we still expect health care expenditures to rise exponentially.

Certainly, government spending is very high.  This is mainly attributable to entitlement and defense spending.  Together, Social Security and national defense represent over 40% of all federal spending.  As a result over the last decade, we have consistently seen public investment less than historical averages.  By continuing this trend, we are threatening our future economic potential by continuing to neglect our transportation systems and limiting access to education.

Both political parties agree that deficit spending cannot continue at its current pace, but there is vehement disagreement on how to pursue meaning debt reduction.  Most Republicans wish to lower the deficits on government spending cuts alone, while most Democrats would like to raise tax revenues for the wealthy.  It is unlikely that either proposal will suffice, so middle ground must be found.

Bipartisan support has recently been agreed to with the Gang of Six, which consists of three Republican Senators:  Saxby Chambliss (GA), Chuck Grassley (IA), and Tom Coburn (OK) and three Democratic Senators:  Mark Warner (VA), Dick Durbin (IL), and Kurt Conrad (SD).  Their proposal will achieve cost savings of $3.7 trillion through government spending cuts and boosts in revenues.  Revenues will be increased by limiting the number of deductions and loopholes, but will also involve the lowering of tax rates for all Americans.  Even with the projected decline in individual income tax rates, revenues are expected to increase by approximately $1.3 trillion, which tells you how much the tax base has eroded over time.

Reverting back to the pending budget crisis, we see that the U.S. Treasury has fully exhausted tax revenues and are restricted to issuing bonds to meet future obligations.  Therefore, Treasury Secretary Timothy Geithner instituted these three measures in order to continue regular operations until August 2nd:

  1. Discontinue issuing State and Local Government Series securities program that assisted state and local government in issuing bonds;
  2. Suspend investments from the Civil Service Retirement and Disability Fund; and
  3. Suspend investments from the Government Securities Investment Fund.

In other words, the U.S. government has been able to fund operations by redirecting promised retirement funds of federal employees toward continuing governmental operations.  Of course, all of these funds will be reinvested back to federal employees when the debt ceiling is raised.

Even if the debt ceiling is not increased by August 2nd, it is believed that the U.S. government will be able to partially fund operations.  However, it will not be known how funding will be prioritized.  One would think that the U.S. will pay interest for bondholders and avoid default.   We would also expect essential military personnel to be paid, along with individuals on Social Security.  However, small business contracting with the federal government and various federal employees would be at risk of not being paid.  As time goes by, it can get quite messy as to who will get paid and how long they can expect those payments.

It is expected that the cost of not increasing the debt limit will be significant, but uncertainty reigns.  We will definitely lose our top credit rating, so that would conceivably make U.S. debt less attractive to investors.   The main concern would be investors fleeing U.S. bonds, which would force interest rates to rise.  That would be a concern because all other credit instruments would rise along with them.  That would mean higher interest rates on mortgages, credit cards, and other sources of consumer credit.  Businesses would also be affected because their interest costs would also increase.  Both scenarios would decrease economic activity and likely drive us back into an official recession.

On the other hand, it is expected the U.S. will exhaust all possible means to avoid a default due to its catastrophic consequences.  Even though foreign countries find the current deadlock distasteful, there are some, who speculate that they will continue to hold onto U.S. bonds because so much economic activity is traded in dollars.  For instance, crude oil is traded in dollars, so it is unlikely that commodity investors will abandon the purchase of U.S. bonds.

Then there’s China, who is an exported-driven economy.  One outcome of China selling their U.S. bond holdings is that it will drive the value of the dollar down.  A lower dollar will mean that U.S. goods are cheaper and that would make Chinese exports vulnerable.  Therefore, it is in the interest of China to continue to buy U.S. bonds to stabilize its value.

No one knows what would happen if inaction extends beyond August 2nd, but does anyone want to chance that?

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