Explaining the debt ceiling debate
By Glenn Kessler,
Andrew Harrer/Bloomberg “It isn't true that the government would default on its debt because, very simply, the treasury secretary can pay the interest on the debt first and then, from there, we have to just prioritize our spending…. It is scare tactics because, Bob, the interest on the debt isn't any more than 10 percent of what we're taking in. In fact, it's less than that. And so the treasury secretary can very simply pay the interest on the debt first, then we're not in default. ”
— Rep. Michele Bachmann (R-Minn.), June 26, 2011, on CBS’s “Face the Nation”
“If we never raise the debt ceiling again, we're going to pay our bills, we're going to pay Social Security. …We won't default. We'll be going back to budget levels of about eight years ago.”
— Sen. Jim DeMint (R-S.C.), June 26, on CNN’s “State of the Union”
“If Congress fails to increase the debt limit, the government would default on its legal obligations – an event unprecedented in American history. This would cause investors here and around the world to doubt, for the first time, whether the United States will meet its commitments. That would precipitate a self-inflicted financial crisis potentially more severe than the one from which we are now recovering.”
— Treasury Department fact sheet, “Debt Limit: Myth v. Fact”
Confused about the debt-limit debate?
This is turning into one of those classic Washington showdowns: A political event is being forced by an extremely technical matter that few really understand. The debt limit is really what filmmaker Alfred Hitchcock used to call a “MacGuffin” — a device used to propel the plot forward, even though it may be meaningless.
Congress instituted the debt limit back in 1917, during World War I, so that it could stop having to approve every single spending request by the Treasury — but still have a measure of control over spending.
Even under the most conservative budget plans, the United States would have to keep adding to the national debt in order to meet all sorts of current obligations, such as Social Security payments, Medicare and the wars in Iraq and Afghanistan. So the debt limit will have to be raised, one way or the other.
But lawmakers are using the pending breach of the debt limit, currently estimated to be in early August, to force the administration to accept significant cuts in spending. (Republicans have ruled out raising taxes.)
That’s their prerogative. In Washington, there is apparently nothing wrong with playing politics with the debt limit. When he was a senator, President Obama famously refused to approve a debt limit increase in 2006 without a plan to reduce the deficit. Now, he calls that “a political vote.”
In any case, we have now reached the stage where some lawmakers — see the Bachmann and DeMint quotes above — shrug off the potential consequences of not reaching an agreement in August. But the Treasury Department warns that this event would be “unprecedented” and three credit-rating agencies — Standard & Poor’s, Moody’s and Fitch — have warned the United States could lose its triple-A credit rating if a deal is not reached by August 2.
“Unprecedented” may be a stretch. There are actually three instances when the United States could be seen to have defaulted on its obligations — in 1790, in 1933 and in 1971.
The first, in 1790, was when the new country assumed the Revolutionary War debts of the states and interest on those bonds was deferred for a decade. The last, in 1971, was when the President Richard Nixon unilaterally broke with international agreements to trade dollars at a fixed rate of gold ($35 an ounce.), in what some would call an explicit default.
Neither of these instances exactly mirror the current situation, but the 1933 case may be an interesting parallel.
When Franklin D. Roosevelt became president in the midst of the Great Depression, U.S. bonds had a clause that gave holders the option of being paid in gold coins.
But Roosevelt wanted to depreciate the value of the dollar relative to gold — by more than 50 percent — so at the urging of the administration, Congress passed a joint resolution canceling all of the gold clauses. Holders of the bonds thus were denied an instant windfall. Congress in essence repudiated the government’s obligations and bondholders were left with depreciated paper money.
Roosevelt also issued an executive order ordering Americans to give up any gold holdings under threat of criminal penalty — and it remained illegal to own gold until the 1970s.
The Supreme Court, in a 5-4 ruling, essentially upheld the ability of Congress to change the terms of bonds, even though it found the action distasteful and unconstitutional.
Alex J. Pollock, a former banker at the American Enterprise Institute who has written on this case, points to that action — and Nixon’s in 1971 — as the start of a long slide in the value of the dollar, to where it is now just “fiat currency,” untethered to an actual commodity. Now, the dollar’s value stems from a perception of the U.S. economy and the dollar’s perceived value versus other currencies.
Administration officials dismiss this as a precedent because they argue bondholders got paid, just in a different form than they expected. In any case, Congress’s action then did not spook the markets.
The big question is whether the markets will be spooked this time. The threat by the rating agencies seems real enough. “When people say the United States has never defaulted on its debts, it is true that that is false,” Pollock said. “It doesn’t mean that I recommend it.”
Pollock said that because the dollar rests only on the U.S. reputation, a technical default might be accepted by the markets as long as it is apparent that a deal will be reached in due time and the Treasury will start printing money again. (It also might depend on how the markets perceive the deal.)
This brings us to the Bachmann and DeMint solution — that there is no need to actually default on Treasury securities. In their view, the Treasury needs to cut other spending, or not pay or delay other, less important bills. DeMint’s staff points to a couple of Mercatus papers that lay out some of these options, which can be found here and here.
“If we were to return to 2003 spending levels, hardly a time of miserly spending, we’d be running a surplus instead of a deficit,” said Weston Denton, a spokesman for DeMint. “Since 2003, tax revenues have increased more than 20 percent, yet spending has skyrocketed by about 60 percent.” (Bachmann’s spokeswoman did not respond to an inquiry.)
Bachmann is correct that interest on the debt is less than 10 percent of the U.S. budget — see table 1.1 of this Congressional Budget Office report — but she makes it sound too easy. So does DeMint’s spokesman with his reference of returning to 2003 spending levels.
The Congressional Research Service recently crunched the numbers, and they are pretty grim. The time frame is a little different than an August default (the CRS report measures spending between April and Sept. 30, the end of the fiscal year), but the ratio should remain the same.
Assuming revenues could not be raised, the cuts in spending immediately would be about 42 percent. Even if all discretionary spending were eliminated — and that would include defense spending — mandatory spending (such as Social Security, Medicare, and Medicaid) would still need to be reduced.
Since it is not an option to halt border security, air traffic control or the wars in Iraq and Afghanistan, then payments to the elderly would need to be delayed or health procedures not funded. In theory, some payments to suppliers could be put off for a period of time — what in the business world is known as “leaning on the trade”— but for what it is worth, the Treasury Department argues that this would be perceived as “default by another name.”
The Pinocchio Test
The Treasury claim that a default would be “unprecedented” is possibly overstated (There have also been various individual state defaults over the last two centuries.) It is possible that the date of Aug. 2 is not etched in stone, either to make payments or for the markets to conclude the United States defaulted. But we are not sure one would want to risk finding out in the current period of economic uncertainty.
In any case, Bachmann, DeMint and other lawmakers opposed to a debt ceiling increase are making it appear much too easy to deal with a failure to reach a deal. The United States is a huge employer, with a tremendous impact on the U.S. economy; it is not a corner five-and-dime store that can put the check in the mail a few days late or reduce the number of pencils it decides to stock.
President Obama has already made it clear that he regrets his wrong-headed political vote from five years ago; lawmakers today should think twice about how they might feel about their votes five years from now. DeMint and Bachmann get two Pinocchios.