The Truth About the Debt Ceiling
Separating economic fact from economic myth
Editor's Note: Reason columnist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.
The statutory debt limit, or debt ceiling, was designed to control congressional spending by limiting the amount of debt the federal government could accumulate. Clearly, it has not fulfilled its legislative purpose. In fact, the government has lost its ability to monitor its own spending. Having to raise the debt ceiling yet again is a sign that Congress has failed to do what is necessary to get the nation's finances in order. Here are three myths about the debt ceiling, each one rebutted by a fact.
Myth 1: Failure to increase the debt ceiling is insanity. Unless we increase the debt ceiling, the U.S. government will default on its debt.
Fact 1: The federal government has other options. If the debt ceiling is not increased, the Treasury Department can make interest and debt payment its first priority to avoid a default. Then it can essentially put the government on a stringent pay-as-you-go basis.
The Obama administration warns of an economic armageddon if Congress doesn't raise the debt ceiling. It is called "insanity" not to take the simple step of allowing the government to borrow more money. Treasury Secretary Timothy Geithner has warned that if we don't increase the debt ceiling the U.S. would default, resulting in a bond market crash with disastrous impacts felt at home and abroad.
Really?
Technically, if the debt nears its statutory limit, the Treasury Department cannot issue new debt to manage short-term cash flows or manage the annual deficit—the government may therefore be unable to pay its bills. But in the real world things are different.
First, if the debt ceiling is not increased it doesn't mean the federal government will have to repay the entire debt at once. The government just won't be able to increase its borrowing. Americans understand the difference between not being able to borrow more money and defaulting on one's mortgage.
Also, while Congress has never before refused to raise the debt ceiling, it has frequently taken its time about doing so (see the chart below). In 1985, for example, Congress waited nearly three months after the debt limit was reached before it authorized a permanent increase. In 1995, four and a half months passed between the time that the government hit its statutory limit and the time Congress acted. And in 2002, Congress delayed raising the debt ceiling for three months. It took three months to raise the debt limit back in 1985 as well. In none of those cases did the world end.
More importantly, the Treasury Department has other options. For instance, if the debt ceiling is not increased, the Treasury can prioritize interest and debt payment to avoid a default. The chart below shows what part of the budget Treasury needs to cover with tax revenue to avoid a default.
If Congress refuses to raise the debt ceiling, the federal government will still have more than enough money to fully service the debt. This year, for instance, about 6.1 percent of all projected federal expenditures will go to interest on the debt, and tax revenue is projected to cover about 60.1 percent of all government expenditures. With roughly 10 times more income than needed to honor its debt obligations, why would the government ever default?
Let's sum it up: As long as the government continues to pay interest on the debt, then it technically is not in default. With tax revenues expected to be $2.2 trillion, interest payments amount to roughly $300 billion—this would still leave $1.9 trillion in revenues to pay for the government's most important priorities. For instance, lawmakers could decide to honor the promises made to people benefiting from entitlement spending, such as Social Security, Medicare, and Medicaid. In that case, even after paying for all of the entitlement spending, the Treasury would still have $300 billion left.
Would that involve cuts in government spending? Absolutely. But it could, and should, be done.
Would it make the bond market nervous? Yes, it would. Not raising the debt ceiling would probably introduce additional uncertainty. However, market participants (especially foreign creditors who now own a majority of our debt held by the public) may have already changed their expectations due to the increased attention to this issue and because of the alarmist language being used by the Treasury and White House.
With some signs of life—such as increases in consumer spending—we could expect declines in demand for Treasury and fixed-income assets. However, the Federal Reserve is still actively purchasing notes, which will likely increase demand. Ultimately, it makes predictions on the effect of interest rates very tricky.
One thing is certain: not increasing the debt ceiling will make us travel to a new equilibrium, which almost always means a certain level of disruption in the short term. But shouldn't such change be the easiest way to mitigate short-term concerns while moving to a more sustainable long-term equilibrium?
Those who are worried about default should realize that our ability to remain solvent depends on our continued commitment and ability to pay the interest on our debt, not on our willingness to raise the debt ceiling. As long as we continue to run deficits, our ability to borrow money cheaply, with low interest rates, is the key to avoiding default.
The chart below shows the budgetary impact after a 1 percent increase in the interest rate.
This could change if investors become worried about their chances of getting paid back. In that case, they might find some safer or more profitable place to invest their capital than the United States government. Also, they may demand an increase in the interest rate for the money they lend. Either of these changes could result if the U.S. government's reputation as a conscientious debtor is called into question by a continued increase in the demand for funds.
The bottom line is that the government must make serious changes to the way it spends and borrows money, it must stop paying the interest on the debt by borrowing additional money, and it must stop making benefit promises it will never be able to deliver.
Both Moody's and Standard & Poor's have warned that our credit rating will be reduced unless we get a handle on our national debt. We've heard a lot recently about the European debt crisis, but, as one senior Chinese banking official recently noted, in some ways the U.S. financial position is more perilous than Europe's. "We should be clear in our minds that the fiscal situation in the United States is much worse than in Europe," he recently told reporters. "In one or two years, when the European debt situation stabilizes, [the] attention of financial markets will definitely shift to the United States. At that time, U.S. Treasury bonds and the dollar will experience considerable declines."
Myth 2: These are extraordinary times. We need to increase the debt ceiling now and will cut spending later.
Fact 2: In the last 10 years, Congress has raised the debt ceiling 10 times, sometimes twice in the same year. Congress has raised the debt ceiling 98 times since 1940. The government has lost its ability to monitor its spending. Having to raise the debt ceiling again is a sign that Congress has failed to do what is necessary to get the nation's finances in order.
The chart above shows the increase in the debt ceiling over the last 70 years. When the statutory debt limit was instituted in 1939, its explicit goal was to limit congressional spending. That purpose is supposedly still the same today. And this limit did work for a while. The chart below shows increases in the federal debt and the statutory debt limit since 1940. As you can see, from 1940 to the beginning of the 1980s, the debt and its limit grew slowly.
The years in which the limit was raised a single time are noted by squares; years in which the limit was raised twice are noted by triangles. The statutory debt limit legally caps, at an amount legislated by Congress, the amount of debt that the United States Treasury may issue. This limit is currently fixed at $14.3 trillion, and our rapidly accumulating debt burden is approaching the cap—as of last week, the outstanding debt subject to the limit was $14 trillion. As federal debt nears this limit, there will be real consequences for the operation of the federal government. Once the debt limit is reached, the Treasury will be unable to issue new debt to manage annual deficits or short-term cash flow issues. In other words, the government may not be able to pay its bills.
Myth 3: Democrats are the big spenders and are the party of debt. We know this because they now want to increase the debt ceiling while Republicans oppose the increase.
Fact 3: Historically, the party in power always wants to increase spending. As a result, lawmakers in power—regardless of party affiliation—overwhelmingly vote to increase the debt limit.
The charts below come from the blog of Urban Institute economist Donald Marron. They show which party voted for the debt ceiling in the Senate and in the House over the last 10 years, revealing that overspending is a bipartisan disease.
Consider, for example, Senate votes on stand-alone debt limit measures over the past decade.
As Marron explains: "When Republicans held both the Senate and the White House (2003, 2004, 2006), they provided virtually all the yea votes, while almost all Democrats voted no. When the Democrats were in power (2009, 2010), the roles reversed: the Democrats provided all but one of the yea votes, while Republicans voted no. Only when government was divided—with a Democratic Senate and a Republican president (2002, 2007)—has the vote to lift the debt limit been bipartisan."
And as the chart below shows, the same voting pattern occurred in the House.
In conclusion, the data presented above reveals that the debt limit, far from providing fiscal discipline, has in fact served only as a symbolic cap that Congress, regardless of the party in power, will simply push higher and higher as spending increases dictate.
Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.