The Debt Ceiling "Crisis" (Brown)

The Debt Ceiling “Crisis”

by Dr. Scott Brown, Chief Economist, Raymond James

July 18 – July 29, 2011

The debt ceiling crisis heated up last week, as Moody’s and Standard & Poor’s threatened to lower the credit rating on U.S. debt. The financial markets appeared not to notice or to care, but may simply be expressing a confidence that the debt ceiling will be raised in time. After all, we’ve been here before. As dysfunctional as Washington is, lawmakers aren’t foolish enough to cause a self-inflicted financial calamity. Or are they?

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The government budget is made up of spending and revenues, and if revenues fall short of spending, as is usually the case, we have a deficit. The national debt is the total of past deficits. The debt ceiling is something of an historical artifact, designed originally to limit the debt build-up during World War I. It doesn’t make much sense to have a debt limit. After all, lawmakers have some control over the annual budgets. They could limit the size of the debt by limiting the size of the annual deficits. Normally, the debt ceiling is raised without much fanfare. Occasionally, there is a sharp political battle.

Note that Senator Obama voted against raising the debt ceiling in 2006, while the current Republican leadership (McConnell, Boehner, Ryan) seemed to have no problem voting for debt ceiling increases totaling more than $5.3 trillion during the previous administration. That’s politics.

The current debt ceiling crisis is a manufactured crisis. There are two issues here. One is the long-term budget outlook. The other is the debt ceiling itself. These two issues have been merged together to create the current crisis.

The U.S. has run very large deficits in the last couple of years. That’s because the recession reduced tax revenues and boosted spending (extended unemployment insurance benefits, food stamps, etc.). The budget deficit will improve as the economy recovers. In the first nine months of the current fiscal year (which ends in September), Treasury reported an 8.6% increase in revenues relative to the same period in FY10. That’s despite a 2-percentage-point reduction in payroll taxes this year. Obviously, stronger economic growth would lead to even better improvement in tax receipts.

The problem with the budget outlook is long term. As the baby-boom generation retires, there will be more strains on entitlements, especially Medicare. Note that Congress can’t do much about interest payments, but if it left Medicare, Social Security, and defense untouched, and cut all other spending to zero, we would still have a budget deficit this year. So the choices are cut spending (including some portion of entitlements), raise taxes, borrow more, or some combination.

Currently, the U.S. has had no problem borrowing. The 10-year Treasury yield is below 3%. The Fed’s asset purchase program, now ended, was only a small part of that. In a severe recession, there’s typically a huge demand for safe assets. Over time, as the economy improves, demand for safe assets will decrease. That means that there should be no concern with running large budget deficits now, but it’s absolutely critical that the deficit be reduced in the years ahead.

The debt ceiling crisis could be eliminated simply by raising the debt ceiling. However, Washington will still have to generate a credible plan to reduce the deficit in the years ahead. The problem is using the debt ceiling a bargaining tool. Some people think that this is the only way for the two parties to come to an agreement on a long-term budget plan. However, it’s not worth risking the credit of the U.S. government.

It’s still widely expected that an agreement to raise the debt ceiling will soon be reached, but what if that doesn’t happen? As Moody’s indicated it’s not just the credit rating of the U.S. government that’s at stake, but also everything related to it: Fannie Mae and Freddie Mac debt, 1000s of municipal securities, even the debt of Israel and Egypt (I guess that means that markets could go “Old Testament” – or a catastrophe of biblical proportions). This is not something to mess with.

Some think that by not raising the debt ceiling the government will be prevented from spending more than it takes in. That’s a failure to understand the budget process. The money has been allocated. If the debt ceiling is not raised, interest payments would likely be made, but Medicare payments, Social Security payments, and veterans’ benefits may be delayed. Government workers may be sent home, but eventually paid (whether they work or not). Government contractors may not be paid on time. If this sounds like madness, well, as Forest Gump’s momma said, “stupid is as stupid does.”