Debt Ceiling Fight Club

EXPERT COMMENTARY

Debt Ceiling Fight Club

By Veronique de Rugy |
Sep 19, 2012

At the current rate of federal spending, the national debt will crash through its legal $16.4 trillion limit by January 2013. When that happens, both sides of the aisle will be hoping to avoid a repeat of the hysterical debt ceiling showdown in the summer of 2011. The Democrats have not managed to pass a budget in years and do not have plans to reduce our mounting debt. Republicans generally wind up trying to weasel out of whatever spending cuts they agreed to before the ink on the deal has dried.

Treasury Secretary Timothy Geithner has argued that when the time comes to raise the debt limit, members of Congress should avoid another debate about offsetting the inevitable hike with cuts in spending because of the “drama and the pain and the damage that they caused the country” last time around. Geithner would rather have the power to raise the debt ceiling when cash is needed, with no strings attached.

While the Treasury secretary is correct that any call to cut spending will cue much drama, he is wrong that we should avoid it. In fact, precisely what this country needs right now is another epic fight over the national debt. Only this time, when the smoke clears, we need to see actual spending cuts that kick in today, not fake promises of fiscal responsibility tomorrow.

As the Cato Institute’s Jagadeesh Gokhale explained in Politicoon June 7, in the previous showdown “the only pain and damage that resulted was probably to [Geithner] and his staff—who had to figure out ways to keep the federal spigot open in case the Treasury’s borrowing authority expired during early August last year. Financial markets and the economy provide no evidence for the Treasury Secretary’s ‘pain and damage’ claims.”

Gokhale is right. While many argue that the Standard & Poor’s (S&P) ratings downgrade for U.S. bonds last summer was a direct result of Republican opposition to raising the debt limit without significant spending cuts, the reality is different. It was Washington’s unwillingness to cut spending and put us on a sustainable path, not the melee staged for the cameras, that caused the downgrade. Weeks before the August 2011 debt limit deal, S&P warned that it would downgrade the U.S. bond rating unless lawmakers took credible steps to reduce government spending. S&P laid out clear criteria for avoiding a downgrade: 1) reduce the debt by about $4 trillion, 2) agree to a credible plan within three months, and 3) guarantee this newfound fiscal discipline will stick.

S&P wasn’t bluffing. When an agreement was reached to raise the debt ceiling by $2.1 trillion as part of the Budget Control Act (BCA) of 2011 without the kind of credible debt reduction measures that S&P asked for, the U.S. lost a notch on its AAA rating. S&P correctly concluded that the deal was a joke. The debt reduction package was much smaller than the one demanded by the ratings agency, committing only $900 billion in spending cuts through budget caps, plus another $1.2 trillion in deficit reductions.

Only in Washington would anyone believe that a promise to reduce the debt by $2.1 trillion over 10 years in exchange for $2.1 trillion in new debt right now is fiscally responsible. Especially since all parties were well aware that more debt would be required within the next two years. Even if all spending caps and cuts were implemented, government spending would still grow from $3.6 trillion in 2012 to $5.2 trillion in 2020, including a 10 percent increase in military spending above and beyond war spending.

The BCA did not make significant changes to the programs that hold the key to our long-term fiscal sustainability: Medicare, Medicaid, and Social Security. Nor did the deal provide credible guarantees that Congress would go through with all of the spending reductions. In fact, since the deal was signed, Republicans and Democrats alike have been looking for ways to avoid the cuts. Appropriators have ignored the budget caps imposed by the law, and many lawmakers have been vocal about reducing the automatic budget cuts set for January 2013.

Geithner’s threatened “pain” and “damage” also did not materialize. Interest rates stayed low as markets shrugged off last year’s contentious debt ceiling negotiations. This reaction is evidence that investors never truly feared the government would default on interest payments owed to bondholders. That’s because if an agreement had not been reached, it is likely that the government would have paid the $29 billion it owed bondholders in August and decided which expenditures not to pay for at that point.

That being said, it would be dangerous to read the country’s low interest rates as a sign of its credit­worthiness. The Federal Reserve is keeping rates low in the hope of boosting the economy. Another reason for our low interest rates is that most other countries are in even worse fiscal shape than the United States. This extraordinary situation, which makes the U.S. look better than it should, cannot continue forever.

Perhaps more important, economists have shown that in some countries (excluding Japan) very high levels of debt haven’t led to a systematically large increase in interest rates. In a recent National Bureau of Economics working paper called “Debt Overhangs: Past and Present,” economists Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff show that in 11 of the 26 cases in their sample, countries in which debt exceeded 90 percent of GDP for at least five years did not experience an increase in interest rates.

But stable interest rates are not a sign that these countries are in good shape. Economic growth in the 26 cases was 1.2 percentage points lower than in other periods, “the average duration of debt-overhang episodes is 23 years, and it produces a ‘massive’ shortfall in output that is almost one-quarter less, on average, than in low-debt periods.” In other words, the fact that bond markets are blasé about high levels of debt in countries perceived as safe tells you very little about how well they are doing. It certainly should not be mistaken for a signal that the government can borrow more without risk.

Yes, the fight over raising the debt ceiling last year was brutal. But markets and investors are not afraid of a little political hair pulling and eye gouging. The real horror was that neither side was serious about cutting spending. And for that to change, things are going to have to get a lot uglier. 

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