The Latest Circular Firing Squad

Okay, what’s a debt ceiling?  

It all started back in 1917 when Congress enacted the Second Liberty Bond Act. [1] The purpose of the legislation was to help finance the entry of the United States into the First World War while holding down interest costs. As the act’s name suggests, it authorized the issuance of long term debt instruments called Liberty Bonds.

Of course, this wasn’t the first time the federal government went into debt or issued debt instruments. What was different this time was the flexibility afforded to the Treasury Department. Previously, debt was authorized on a one-by-one basis. For example, a specific loan was authorized for the Panama Canal. But with the Liberty Bonds a total aggregate debt was authorized. Congress didn’t set a specific amount of money to be borrowed, but set a top limit under which Treasury could operate as it saw fit to meet changing circumstances.

After that, Congress started setting different debt limits for various categories of debt. Finally, in 1939, Congress set an aggregate limit that covered almost all of the federal debt so that Treasury could manage the federal debt in the way that seemed most appropriate under the circumstances. From that point, although Congress set a limit on the total debt that could be incurred, the debt ceiling, it no longer micro-managed the manner in which the debt was handled, and Treasury could adjust its strategy to adapt to changes in the financial markets. Since that time, the debt ceiling has been adjusted (upward, of course, but sometimes downward) in order to meet the nation’s debt obligations.

Now the practice of Congress is usually to authorize expenditures totaling more than the amount of revenue the government receives from taxes and other sources. That, however, doesn’t automatically raise the debt ceiling, which has to be separately authorized. Thus, it is possible for the government to incur debt without authorizing the financing of that debt. If Congress directs the building of a dam, the dam will be built and a debt will be owed. But if the financing of that debt is not authorized, that is, if the debt ceiling isn’t high enough to accommodate the debt, then Treasury has to pay the debt with cash on hand or the debt will not be paid. It is not to be expected that there will be sufficient cash on hand to pay all of the federal government’s debts. But not paying all debts means that the federal government will go into default on that debt. [2] 

In light of recent events, it cannot be emphasized enough that raising the debt ceiling is something that is done in order to finance debt that has already been incurred. So when members of Congress threaten to not raise the debt ceiling they are not threatening to impose fiscal discipline but to create a situation where the federal government cannot pay its outstanding obligations. They are threatening to default on the public debt.

Now defaulting on the public debt would be just plain stupid. It would impact Treasury’s ability in the future to borrow on the best terms. It would negatively impact the market for Treasury securities, and it would increase the government’s borrowing costs. What’s more, if payment on Treasury securities was delayed it would likely trigger a world economic crisis. Failure to pay contractors and vendors in a timely manner would adversely affect them, and have repercussions throughout the economy. Delayed payment to contractors and on tax refunds could result in interest penalties. All of this would likely happen, and the amount of the public debt would not be reduced in the slightest. Indeed, it would probably exacerbate the debt because of the additional interest costs the government would incur.

In light of all of this, why would our elected representatives threaten to not raise the debt ceiling? Sadly, it appears that politicians are trying to take advantage of ignorance and misinformation to score political points, and the fact that they are threatening harm to the country doesn’t seem to matter to them. Raising the debt ceiling sounds like the authorization of new debt. So when a politician says that he is not in favor of raising the debt ceiling it can sound as though he is advocating fiscal restraint, and those who engage in this practice make no effort to enlighten the citizenry as to what they are actually saying. The time for fiscal restraint is when expenditures are authorized, not when it is time to authorize the financing of the debt thus incurred. But it seems as though there are politicians who would prefer that their constituents not be made aware of this.

Now forcing the country into default hasn’t actually happened yet. It cannot be said for certain that there are enough politicians in Washington who would actually pull the trigger on such a thing. For most of them, it may well be a bluff. Still the utter lack of rationality involved in making such a threat makes our government look unstable. This can itself adversely impact the market for Treasury securities, which have up to now been understood as a completely solid investment. It may seem like they are not such a safe investment with members of Congress threatening to not make good on them, and, indeed, Standard & Poor’s lowered the credit rating of the United States in response to the debt ceiling crisis of 2011. [3]  In response to the recent congressional threat regarding the debt ceiling Fitch Ratings placed the United States on “Rating Watch Negative” [4], and China’s Dagong Global Credit Rating Company downgraded its rating for the U.S. even after the debt ceiling was raised. [5]  

The reason for the latest row over the debt ceiling was the funding of Obamacare. There are reasons to be against Obamacare. There is no reason to force the country into default on the public debt, and, therefore, there is no reason to threaten it. We will be coming up against this issue again in February, and, hopefully, we’ll all be just a little smarter. 

Jack Quirk