Sunday, July 17, 2011

The Two Debt Ceilings

Lots of heat and little light about the debt ceiling this week. The President has set July 22 as the deadline for a deal regarding the debt ceiling, which begs the questions "What is the debt ceiling anyway?" and "Why does Duvall think we have two of them?" I will try to provide links to my sources. I have opinions, one of them is that people should have data before they make statements.

Part I: The Debt Ceiling

For the first question, the answer is the debt ceiling is an arbitrary limit established by Congress in its present form in 1939 (originally in 1917, as part of war bond sales) that sets the maximum limit to which the government may become indebted. Article I Section 8 of the Constitution assigns to the House of Representatives the ability to create bills that allow the borrowing of money on the credit of the United States Government, among other powers. No body or person in the government has or shares that power, it resides in the House of Representatives. Why? Because as the most granular representation of the will of the public (435 elected officials) it is presumed to be the body most responsive to the will of the public. There are only two Senators from each state, and only one President. Although we all vote for the President, he is one person that is expected to represent the entire population. Your House Representative is responsible to only about 600,000 people, and responsible every two years. All laws regarding spending by the government have to be generated in the House of Representatives. The Senate may or may not approve them, the Senate may have their own ideas and the House and Senate get together in what is called a conference committee to hash out the details and make a final bill approved by both houses, but the power of the purse is in the House of Representatives.

Every few years the House of Representatives has voted to increase the debt limit. Usually, the party in power votes for the increase and the party out of power votes against it while tut-tutting the profligate ways of the party in power. The current President, in his partial term as Senator for Illinois, voted against a debt limit increase in 2006. His thoughts at the time were,
"The fact that we are here today to debate raising America’s debt limit is a sign of leadership failure. It is a sign that the U.S. Government can’t pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government’s reckless fiscal policies. … Increasing America’s debt weakens us domestically and internationally. Leadership means that ‘the buck stops here. Instead, Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren. America has a debt problem and a failure of leadership. Americans deserve better."
John Boehner, current Speaker of the House, voted to raise the debt limit five times between 2002 and 2007, when his party controlled the Presidency. Both persons now find their roles reversed, both seem a little hypocritical, but hey they're politicians. This is a dance that both parties have done for decades.

The reason that the debt ceiling debate is taking up bandwidth now is that back in March the US hit the maximum indebtedness allowed by law, $14.294 trillion dollars. To put that in perspective, a billion seconds is about 30 years. A trillion seconds is about 30,000 years. Fourteen trillion seconds ago there is no fossil evidence of homo sapiens on the planet. That is a staggering amount of money. The gross domestic product of the United States, the value of all goods and services produced by every person in the United States in one solid year is a little over that level, almost $15 trillion dollars a year. We owe 96% of our GDP in debt ALREADY, before any debt ceiling increase. The wheels fell off Greece when they made it to 120% of GDP in debt, we are not far behind that level. We are only 12th in the world in the debt-GDP ratio, but in terms of total indebtedness we are far and away number one with a bullet. Greece is underwater with a paltry $500 billion in debt, we owe 28 times what they owe.

"But hey," you ask, "it's almost August and the debt ceiling was hit in March. How come we aren't seeing mobs march on the Capitol, burning Starbucks stores as they go?" Well, there are a couple of reasons for that. The Treasury has some latitude to short-term borrow from federal pension funds, which has kept us afloat until now. The other reason is that while our government borrows 43 cents of every dollar it spends, tax receipts pay the other 57 cents of every dollar. We don't need to borrow everything to keep going. Tim Geithner, the Treasury Secretary, has juggled the books with the pension money and kept us going this long without having to hit the market for more debt. That pension-fund borrowing is about to run out, so we either raise the debt ceiling or we have to live on the taxes we collect.

So what happens if the government is unable to borrow from itself in this manner after August 2? The answer is that the government will not have enough money to meet all of its commitments, and it will have to begin prioritizing who and what gets paid. Even without access to the international debt markets, the United States collects about $200 billion a month, roughly 57% of what the government feels it needs to make ends. What it costs to pay the interest (the "coupon") on the debt we already have is $20 billion a month or so, well within our means. When politicians use the term "default", they mean the government cannot pay everyone for everything. In the narrow but more important financial definition, "default" means failing to make an agreed interest or principal payment, much like missing a mortgage payment. Anyone who tells you the United States is going to "default on its debt" is misinformed. Unless the President and Treasury Secretary are completely incompetent (ahem) the first payment out the door will go to people holding the public debt of the United States. Should the US default on its debt in the financial sense, the credit rating of the US will drop to somewhere around Greece's and interest rates will skyrocket.

If this happens it will NOT be because the Congress did not raise the debt limit, it will be because the Treasury failed to prioritize payments to debt holders, plain and simple. This eventuality is the one that people worry about, but it is very, very unlikely. The only time the US technically defaulted on debt was in 1979, and the last thing the Obama Administration needs is yet another analogy to the Jimmy Carter administration. We can be reasonably certain that the US government will not default on its debt, but with 57 cents to cover every dollar of commitments, somebody is going to get shafted. So who is that going to be?

Although the President shamelessly attempted to scare those dependent on Social Security payments, SSI consumes only about $60 billion a month, meaning that those payments can very safely be made. If you add in Medicare, the military, funds needed to support troops in Afghanistan and Iraq, you get pretty close to the $200 billion that we take in every month. Other things will have to go by the wayside. National Park Rangers, Border Patrol, FBI, Department of Education, Department of Agriculture, school loans, etc. As Chief Executive, the President will have to see how much can be done with the tax reciepts, what will happen is not a default but in essence a partial government shutdown, with the Chief Executive responsible for turning out the lights in the parts of the building that cannot be paid for. There have been government shutdowns in the past, but full shutdowns where people's government benefits have been threatened. This will be different: there is legally-authorized money, just not enough for everything.

The job of the President as Chief Executive is to see that the programs established by Congress are run properly and the money spent appropriately. There was an amendment to the constitution, the 14th Amendment adopted in 1868, that has gotten some press recently in the discussion about the debt ceiling. The main reason we remember the 14th Amendment has been for the Equal Protection Clause, upon which a large body of civil law including anti-discrimination statues are based. That is Section 1 of the Fourteenth Amendment. Section 4 is what is being debated now, quietly and in corners, as to the power of the President to ignore the debt ceiling. Section 4 reads:

Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.

It is the first sentence that is in debate. Reading the entire Section and understanding the context as a response to the Civil War, the gist to me is that "Yes, the Confederate States of America owes you money. No, the United States of America is not going to pay it. We are going to ignore the CSA debt because we won, but any debt we issued is going to be honored." Reading the first sentence only, some people argue that because the validity of the public debt of the United States...shall not be questioned the President has a Constitutional duty to ignore the debt limit if Congress does not authorize raising it, and order the Secretary of the Treasury to continue to offer debt after August 2.

The Fourteenth Amendment was adopted over 70 years after the Constitution, which gives it "precedence" -- it has to be evaluated first. If the President decides to use this authority to offer debt above what the Congress has authorized, it will create a "Constituional crisis": the Executive Branch will be appropriating powers given to Congress and the House specifically, and it will be up to the Judicial Branch (eventually the Supreme Court) to decide who wins. There are people that have made arguments on both sides, but I find the argument that the President cannot do this to be more compelling. The Constitution is hostile to rule by fiat, and the 14th Amendment in context is a different story, to my non-lawyer-but-originalist interpretation. I can tell you what Scalia will say, in any event. This will be bad, because if the President authorizes the sale of debt against the will of Congress I would not want to be holding that debt. If negated by the courts the claim of debt holders against the government would be...suspect at best. The markets do not like 'suspect', I imagine that debt will be somewhat undersubscribed.

A 14th Amendment end-run I therefore see as unlikely. What should happen, and what will happen, is that the House of Representatives will pass a bill to raise the debt ceiling, with some conditions. The shape of those conditions is what the debate has been about in the past weeks, a debate that will reach a fever pitch in the coming week. Any agreement to raise the debt ceiling will be accompanied by some combination of offsetting budget cuts and/or tax increases, so that the US has the freedom to borrow to meet cashflow requirements but in essence doesn't have to borrow as much in the future. It's important to know the players and their ideological positions, some inference on my part will follow.

  • President Obama has stated his position that the issue should be addressed with shared sacrifice. He is absolutely committed to tax increases in addition to spending cuts as part of the offsets to the debt ceiling raise. He wants a debt ceiling raise that is large enough that it will not have to be addressed again until after the 2012 elections. When the idea of a short-term raise in the debt ceiling raise was offered, to allow more time for shaping a larger deal he declined, warning "Don't call my bluff" on a short-term deal before storming out of the meeting. He has not been present at the meetings that have occurred in the months leading up to now, sending Vice President Joe Biden to attend the meetings. The details of the proposals in these meetings are not public, but he has yet to propose any change in the entitlement programs (Medicare/Medicaid, Social Security, others) that will comprise ever-larger portions of the federal budget in upcoming years. The tax increases he wants are also not specified but he has mentioned eliminating some depreciation allowances on oil companies and corporate jets, as well as closing other tax loopholes for "millionaires and billionaires". What is certain is that any proposal acceptable to him must have tax increases as a part of the mix.
  • John Boehner, the GOP Speaker of the House, has not expressed personal opinions as to the composition of the offsets for any debt increase. He has clearly expressed that he does not have the votes to pass any legislation that increases taxes as a part of the debt ceiling increase. The GOP House will not accept that proposal and chances are good that even with 100% House Democrat support of any tax increase plan there are not enough Republicans willing to cross the line to form a majority. The plan at this point is to cut $2.4 trillion from the Federal Budget over the next 10 years, in return for a debt ceiling increase of $2.4 trillion. That will get the President the term on the deal he wants through the 2012 election, but not the composition. The GOP House has already announced that they will take up the measure today, Tuesday July 19th, and given that they have a majority it will almost assuredly pass.
  • Mitch McConnell, GOP Senate Minority Leader, is working on a plan that will allow the debt ceiling increase in automatic intervals for a total of $2.4 trillion in the next two years, with the President required to send a list of offsetting cuts to the federal budget that may or may not be approved by Congress. This is kind of a head-scratcher, but it forces the President to detail cuts to get money while allowing the GOP to vote against debt increases. The best description of it is here (Keith Hennessey is wicked smart), opinions vary and analyses I have seen are largely positive or negative depending on the analyst. McConnell is doing this because the House plan will almost assuredly not pass the Democrat-controlled Senate, and there needs to be something on the table or there will be no debt ceiling increase on August 2. Unfortunately, this is unlikely to pass the GOP House so its validity is in question.

The reason for the headache over the composition of the deal is that the GOP does not trust the Democrats to propose actual spending cuts; however, they believe the tax increases will be not only entirely real but detrimental to the economy. The Democrats know the people who will elect them will pillory them if they make cuts to Great Society or New Deal-era programs, support for which largely defines the Democratic Party, and they think the wealthiest Americans have gotten a free ride for the last decade, and should pony up.

Some inconvenient realities are that if you seized ALL of the income of the top 2%, leaving them no income for the year, it would still not close the budget deficit this year...and what would you get out of them next year? Would they even work? Would they still be Americans or would they be economic refugees? Depending on income tax increases for the wealthy to pay for this is a bad idea, particularly because those taxes will also hit small businesses, and economically speaking we are not out of the woods yet.

President Obama acts as if tax increases are not already on the way. There is a raft of tax increases coming in 2013 to pay for Obamacare (the Patient Protection and Affordable Care Act), detailed at the link. Furthermore, the two-year extension of the Bush tax cuts expires in 2013 as well, a bit of a double whammy for the people who largely fund small business in the United States. The tax increases the President wants as part of a debt ceiling deal are in addition to all these taxes that are going to increase on their own already.

Tax receipts as a percentage of GDP are down considerably from the Bush years, this chart from the Tax Policy Center shows that compared to a historical average of tax collection in the US since 1950 of 16.9% of GDP, tax receipts are down to 14.9% of GDP, tax collection was as high as 18.5% even with the Bush tax cuts in 2006. People who want to raise taxes will point to this and say "Stop whining, you're paying far less in taxes than you ever have". People who don't want to raise taxes will point out that the tax receipts by %GDP are probably low because the economy sucks. In 2006, we had 5% unemployment. Our stated rate is now 9.2%, and the real rate is probably somewhere in the mid to upper teens. With a better economy we can get back to historic rates of tax collection by %GDP fairly quickly, and increasing taxes is unlikely to boost the economy. The opposite may be true.

On the spending side, the situation is a whole lot less nebulous: we're spending far more money than than we ever have, both in dollars and in percentage of GDP. The last time we had a budget surplus (2000) we spent 18.2% of GDP and collected 20.6% of GDP in taxes. During President Bush's term, spending increased as a percentage of GDP, and with the stimulus, the bailouts and a variety of other reasons the government spent the equivalent of 25% of GDP in 2009 while collecting only 14.9% in taxes. There are some confounding factors, the peaks of tax collection were the dot-com and real estate bubble years where the wealthy paid a staggering amount of capital gains taxes, but the fact remains that we have gone from spending 18.2% of GDP to spending 24-25% of GDP in the last couple of years. Tax collections will vary with the economy, but our spending has dramatically outstripped the historical standard.

To summarize the first part:
1. The debt ceiling is approaching on August 2.
2. Very doubtful that the US will default on its debt, very likely that absent a deal there will be a painful partial government shutdown.
2. Opinions vary about what to do about it, largely on ideological lines. The President and Democrats have an ideological bent to preserve spending and increase taxes, because taxes are too low. The GOP has an ideological bent to cut spending, as they believe spending is far above historical levels.

Part II: The Second Ceiling

So far I have discussed the things that are under the government's control. They may or may not reach a deal to increase the debt limit. If they do, they will cut programs, raise taxes or both. If they do not, the President will have to decide what portions of the government to keep operational and what portions to shut down. These are known unknowns, questions that we know there will be answers to though the answers are not yet known.

The larger, and to my mind far more significant problem that the debt ceiling is but a small part of is the staggering amount of debt the United States has accumulated. We are talking about increasing debt by a few trillion dollars to allow for cashflow. The rest of the world is far more concerned about our existing debt, and the obligations that we have made that are not part of the debt: Social Security, Medicare and other entitlement programs that are a demographic certainty to destroy our federal budget.

As a nation we enjoy a AAA credit rating. The belief in the veracity of the "full faith and credit of the United States" is strong, so strong that during the economic meltdown in the fall of 2008 when Lehman Brothers went bankrupt and Morgan Stanley agreed to become a ward of Bank of America, investors purchased short-term Treasury bills (T-bills) with a negative yield. They were willing to lose a small percentage of their money (getting back less than they paid) in return for not losing a larger percentage of their money in stocks and other commodities. Our government benefits immensely from this AAA rating, it's worth at least a percentage point of interest on the debt we issue -- which is a lot of money on $14.3 trillion dollars in debt. Every percentage point of interest on that debt that we do not pay is $140 billion a year we save.

Credit ratings agencies have not covered themselves in glory in the last decade. They greenlit an incredible amount of bad debt, part of the causality chain in the residential mortgage meltdown that burst the latest economic bubble in 2008. They underestimated the risk of that debt very badly, but the fact that they are wrong when they call risky debt safe does not mean that they are wrong when they call what has been safe debt risky, and they are doing that now. Standard & Poor's, Moody's, Fitch and others have notified the federal government that they are getting ready to downgrade our debt, to take away the AAA rating that saves us so much money in interest and upset the world's financial apple cart.

I cannot emphasize enough that our credit is about to be downgraded because of our existing debt, and the lack of any Congressional or White House plan or will to stop acquiring debt in the near future. The downgrade has little to do with our debt ceiling, which is an arbitrary cap on the acquisition of debt and which, if enforced, would actually put us on a more sound fiscal footing, albeit with a very low level of federal services. As I have shown earlier, we will not default on our debt even without a debt ceiling raise, absent gross incompetence on the part of Treasury officials, so the warning is not about our short-term inability to pay back debt. The warning is that our debt is already so high, our future plans in terms of what we've said we're going to pay for Social Security and Medicare imply so much more debt and our economy is so anemic for a variety of reasons that S&P thinks it's possible that we will not pay back our debt at some point in the future. S&P and others, will be saying to investors and money managers, "You should ask for more in interest rates if you agree to take this debt, because the United States government may not have the ability to pay you back," which is kind of a staggering statement but one they WILL make without major structural changes in our budgets.

A credit rating downgrade will be a sign that we are getting close to the second, real debt ceiling: the point at which the market will stop treating our debt as something special and start assessing our debt much like that of Argentina or other distressed nations. We have benefited greatly in the past few years by selling debt into a low interest rate environment. The Federal Reserve has cooperated with this over the past year by in essence buying large amounts of debt from the Treasury as it was issued, this was called "Quantitative Easing", and since it was the second such program the Federal Reserve undertook since the 2008 financial crisis, it was called 'QE2' for short. In essence, the Treasury created $600 billion in debt and the Federal Reserve bought it over the last several months, pumping $600 billion into the economy through the government in addition to the 2009 Stimulus money and all the other "pump priming" efforts of the government. The QE2 is now over, and there is talk of QE3 or other efforts to ostensibly stimulate the economy. While the stimulative ability of QE and Keynesian deficit spending are the subject of debate, the effect on the currency is not: both are creating inflation.

Why inflation? Because if you lower the value of your currency you are able pay people tomorrow with money that is worth less that it was when you borrowed it. The Chinese have noticed this, and are not happy. S&P is noticing this, and is not happy. When investors get unhappy they want more interest, and as each interest point is another $140 billion annually on debt we already owe, you can see why anything that jacks up interest rates is detrimental to the nation. We are already looking at about $1.5 trillion in deficit this year, with a 3% increase in interest rates we'll be looking at more like $1.92 trillion in deficit, with interest payments climbing rapidly as new short-term debt is issued. The recent bias toward issuing short-term debt will work against us, in that interest rate hikes will hit the short-term debt faster as we have to roll it over. Just like at your house, the debt builds up faster and faster when you're paying others interest.

The difference between the "second" debt ceiling and the August 2 debt ceiling is that we may have very little notice as to when the markets suddenly decide in a "tipping point" fashion that they don't want our debt anymore. Interest rates demanded for our debt will suddenly climb, and that's not subject to Congressional action. There will come a point, as there has come a point in Greece, where nobody wants to buy our debt at all, and that will be the true debt ceiling as well pretty much the end of America as we have known it. Our options at that point are defaulting on most government obligations or inflation of the currency to pay off our debts. There is even the potential for hyperinflation, when the currency is simply useless. In my lifetime we've seen similar instance in Zimbabwe (2000s) and Chile (1973), the classic example is Weimar Germany between World Wars I and II. Hyperinflation comes because people don't want or trust the currency, barter is preferable because in the time it takes to get from a place where you sell something for money to where you're intending to buy something for money you can lose significant value. Zimbabwe doesn't even have a currency anymore, they use dollars or Euros but their national currency stopped being printed shortly after they started printing $100 million dollar bills. What is a laugh line in 'Austin Powers' was a reality for those forced to use cash in Zimbabwe.

Bad politics can create bad economic situations, but bad economic situations often lead to the worst of bad politics. The worst example of all is Hitler rising in Weimar Germany, but there was plenty of other demagoguery in the 1930s, from Italy to Argentina and elsewhere. The economic shocks of the 1930s brought us great expansion of the federal government under Hoover and Roosevelt, measures that were ultimately unsuccessful at fixing the structural problems of unemployment and economic depression. What was successful at ending the Great Depression was relaxation of the onerous regulation the federal government laid on industry so the US could arm itself for war, and six years of the fiercest combat in human history that successfully if temporarily de-industrialized Europe, at least, by the time our bombers were through with it. That situation is neither welcome, nor likely to come again.

In summary,
1. The real debt ceiling, as opposed to the arbitrary one set by Congress, is when the world stops wanting to buy our debt. This will most likely happen because we cannot pay the debt we already have.
2. This is not subject to Congressional or Presidential control, and it can happen with little or no warning.
3. Credit rating agencies already believe we are close to the end of our means and are threatening to say so publicly, which will hasten the downhill process.
4. Credit rating agency statements are based on the debt we have and the spending we have planned, which looks reckless to them. Just so you know what 'reckless' means to them, they thought making mortgage loans to people with no job or documentation was fine and dandy. By comparison, the federal government's fiscal policy looks foolish.
5. Credit agencies are not threatening to downgrade us over the absence of a plan to raise the debt ceiling. The downgrade will come because there is no consensus plan to deal with our debt or control government spending.

Enjoy the next week!

UPDATE: Since I wrote this on Sunday and Monday, Moody's has announced that they want to see at least $4 trillion cut from upcoming federal budgets over the next 10 years to continue a AAA rating on the United States Government. The "McConnell Plan" and the "Gang of Six" plan announced today will not cut this much. The only plan that cuts enough is the GOP's "Cut Cap and Balance" plan...the one the Democrats say is dead on arrival.


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