Tuesday, March 22, 2011

Everything you ever wanted to know about the debt ceiling, but were afraid to ask

Sometime in early to mid April the United States government will run up against the limit of what it can legally borrow. The so-called “debt ceiling” will be hit and without an increase, the Federal government of the United States will not be able to pay its bills unless it resorts to drastic measures such as huge tax hikes and/or spending cuts. (More on that later.)

What is the debt ceiling?

The debt ceiling is a limit on what the government can borrow. It was created back in 1917, which was back in the time when we were still on the gold standard. Under a gold standard the quantity of money that the government could issue was essentially fixed. It depended on the amount of gold reserves we held because gold “backed” our money. If the government issued all the money it could under the gold constraint, but needed more, it would literally have to borrow. Congress created the debt ceiling as a way to limit government spending and borrowing.

In 1933, however, we went off the gold standard domestically and in 1971 Richard Nixon took us off of it for international payments as well. That meant gold no longer backed our money and the spending constraint was removed. Nowadays, when the government needs to spend it does so by merely crediting bank accounts. (Changing the numbers in your bank account.) Under this system the debt ceiling has really become an anachronism—a relic of a bygone age. So why do we still have to go through this dance every year or so?

Because of one little technicality.

To understand why the debt ceiling is still an issue you first have to understand how the government and the Treasury operate. The U.S. Treasury (the financial arm of the U.S. government) has an account at the Federal Reserve just like you have a checking account at your bank. Under rules that have been in place since the time when we were on a gold standard, the Treasury is precluded from running a negative balance in its account at the Fed. (The U.S. Treasury has no overdraft line of credit!!) This means when the Treasury’s checking account at the Fed gets drawn down to a certain level and cash needs arise, it must sell some bonds to raise the level of its cash balances. If it didn’t do this then technically, under the rules, it cannot continue to spend.

But is the U.S. government really limited in what it can spend?

Under the authority granted to it in the Constitution the government has monetary sovereignty and the power to issue currency. The Constitution places no limit on the spending power of the government, but it does require that the government make good on all its debts. Hypothetically, that means the government can spend whatever it wants, but because of this arcane and outdated rule, we have to go through this ridiculous debt ceiling dance every couple of years.

Can the U.S. default?

The United States has never defaulted on its debts and technically, it is not even possible because all of our debts are denominated in dollars and the United States government is the sovereign issuer of the dollar. However, there is a difference between the ability to pay your debts and the willingness to do so. Just because you have the money to pay doesn’t mean you are willing to pay. Any entity can default if they are not willing to pay what they owe.

To raise or not to raise…

This is the crux of the current debate that is raging along partisan lines in Congress. Some members believe that it is the duty of the U.S. to pay its bills and therefore, the debt ceiling should be raised without delay. Meanwhile, other members think that the spending has gone too far and the debt ceiling should be capped indefinitely even if it means putting the U.S. in default. So the prospect of default come mid April is very real given the current political and ideological environment.

It will likely go down to the wire.

If the debt ceiling is not is not raised we could still avoid a default, but Congress would have no other choice than to implement a series of very rapid and very large tax increases and spending cuts to close the gap. The Congressional Research Service estimates that the government will need an additional $732 billion above what it expects to receive in taxes and fees in order to cover expenses over the next six months. Spending and tax cuts of that size and in such rapidity would absolutely crater the economy.

Hopefully, cooler head will prevail and we will avoid the Doomsday scenario, but one thing looks certain: it will go down to the wire in a very huge and very scary game of brinksmanship.


Tom Hickey said...

This brings up the point — why issue Treasury securities at all when this is operationally unnecessary under the present monetary system? Since interest-bearing Treasury securities are operationally unnecessary, the interest constitutes a subsidy for bondholders. This is tantamount to paying bondholders to occupy a risk-free parking place. Surely, there are better uses for public funds than to subsidize large savers, many of whom are banks. The required offset of currency issuance by the Fed with securities issuance by the Treasury is another corporate subsidy that diverts public funds from public purpose unnecessarily and wastefully.

According to the MMT description of monetary operations under the current system, issuance of Treasury securities drains excess reserves injected into the interbank system from fiscal deficits. Treasury issuance is a monetary operation that drains excess reserves so that the Fed can hit its target rate. What happens is a shift in asset composition and the maturity of government liabilities. There is no increase or decrease in nongovernment net financial assets in monetary operations of this type. The Fed could accomplish the same thing more directly by paying a support rate on excess reserves, which it is already doing.

In fact, there is no need for a separate central bank at all under the present system. The operations of the Treasury and central bank are already de facto consolidated. This should be made de jure by combining the two agencies into one.

Doing these things would reflect the operational reality of the current monetary system and make for greater efficiency.

mike norman said...

And, Tom, a great discussion of this, which you participated in, on Warren's blog!

Mario said...

very good post mike and great job explaining it all.


Get the word out!!

Tom, I get that nfa doesn't change, but can't you call the payments on excess reserves a subsidy as well? So what's the difference? And doesn't the very fact that the government spends increases reserves forever...basically banks "house" all the money in circulation these days since most things are electronic not in cash.

Also if the FFR was set to zero forever as I think you also suggest, wouldn't that effect lending practices, etc. negatively? I mean aren't you just basically saying, let's not have an FFR anymore?

What am I missing here?

Tom Hickey said...

Yes, Mario, support payments on excess reserves are also a subsidy, and they are only necessary if the cb wishes to set the overnight rate under no bonds. Warren Mosler argues that the natural rate of interest is zero, so the FFR should be set to zero, as other cb's (Canada) do with their overnight rate. That would eliminate the bank subsidy.

googleheim said...

"Any entity can default if they are not willing to pay what they owe."

That is a scary statement.

Republicans might try to encourage and to trick US patriot citizens into such economic catastrophe in the name of Austrian school creative destruction deficit terrorism.

They are really a bunch of moronic wimp imps.

Tom Hickey said...

Conservative Bruce Bartlett unloads on the crazies in his party that want a default to prevent the US from ever borrowing again.

Contemptible Advocates of Debt Default