Reposted from Facebook
I suspect most of the people to whom I am linked on Facebook will understand, at least broadly, the idea that the Federal Government not raising the debt ceiling is a bad idea. However, beyond the idea of “we need to keep the government open” or “we need to pay people’s social security,” many may not really understand why. Let me attempt to help out in a reasonably non-technical way.
A trip down history lane
The US Constitution, for all of its longevity and power, has a few very specific provisions in it, and one of those is the idea that spending bills must originate in the House of Representatives. The founding fathers did this because they wanted to ensure that the officials most responsible for authorizing the expenditure of the nation’s treasure were the ones who were most accountable to the people whose efforts and labors paid for it. Thus, if the House of Representatives started spending money in ways that were disliked by their constituents, they would hear it most quickly and most readily at the ballot box.This idea, of being directly accountable to the people, is a good one in theory. In theory, the House would be good stewards of the purse strings, constantly working to spend responsibly and raising sufficient taxes to pay for it all. Unfortunately, the ink was not even dry on the parchment before the nation’s first great debt crisis was upon us. As most of us remember from way back in the days of yore (aka High School Civics class), our current government is actually our nation’s second. The first government, the one that carried us through the War of Independence, did not really work all that well. There was a lot of squabbling over how the war should be conducted, how monies should be spent, and which businesses in which states should get which procurement contracts. In short, it looked a lot like the modern Congress, just with wigs.
Like our modern congress, the Continental Congress ran up a big foreign debt that was used for such trivial expenses as paying troops, buying guns and ensuring that farmers received compensation for putting food in the bellies of the people fighting the Redcoats — nothing serious like ethanol subsidies, bridges to nowhere and federal buildings named after themselves. While the Continental Army was successful (with a generous dollop of help from the French), the war was expensive and the United States were deep in debt to foreign countries. Unlike today, the United States economy was not “too big to fail”, so while many people were of a mind to tell the current bond holders to “stuff it”, the Constitution specifically acknowledged the prior debt (Article Six). What was a newly minted legislature to do?Up until the Civil War and the introduction of the income tax, the Federal Government operated in an environment where it was basically always short on cash. Given its limited ability to tax and the ascendancy of “States Rights”, few people really wanted to lend a lot of money to the government, so the Federal Government was a much smaller portion of our total economy than it is today. It still did some important things, but the specter of debt and borrowing was always front-and-center in the political landscape (not like today where the “Ways and Means” committee — aka Taxes — is separate and distinct from the “Appropriations” committee — aka spending). This state of affairs lasted basically up until the butcher’s bill came due for the major issue not dealt with by the Constitution: slavery. With the Civil War, the Federal Government needed money. It needed a lot of it, and it needed it fast. Welcome to the income tax. Oh, and before you get all nostalgic for the other side, they did something much more harmful to their economy since they didn’t like taxes: they printed money. A lot of it. So much, in fact, that a Confederate Dollar in November of 1864 in Houston was worth 1/50th of what it was in September of 1861. In fact, inflation had gotten so far out of hand that the Confederacy had to basically wipe away one third of its money by the middle of 1864 and issue new bills. Setting aside the moral environment in the south, think about how disruptive it would have been to your family and livelihood if the value of your money had suddenly been reduced by a third. But let’s not dwell on a possible future.
The Marshall Plan
From the Civil War to the end of World War 2, the United States experienced both a significant growth in the total size of its economy and also in the sophistication of its economy. We were blessed with a few unique attributes (large land mass, abundant natural resources, rapidly growing population) right as the industrial revolution got into full-swing. By the time of World War I, the US was the world’s largest economy. By the end of World War 2, the US was the only remaining undamaged economy among the then-developed nations. Into this vacuum stepped the Marshall Plan. With the Marshall Plan, the US re-built western Europe with the idea that getting their economies back on-track would keep them out of the hands of the Communists. This in turn created a huge demand for American products while also cementing the Dollar as the global currency of foreign trade and finance.
This last bit cannot be understated. Global finance is anchored to the US Dollar. The foundation of modern finance is the “risk free rate”, the market rate that provides the “cost” of money being transferred from people who have excess capital (aka money) to those who need additional capital (you know, money). Just like an airline, there are additional surcharges and fees that get layered on top of this for things like needing the capital over a longer time frame (so-called “duration”), or with a less-than-perfect borrower (“risk premium”), or to lend when the supply of money is increasing (“inflation premium”). In fact, modern finance is largely the systematic effort to identify, quantify and exploit sources of risk over and above the risk free rate.For its primary goal, most scholars agree that the Marshall Plan was a huge success. The US had economic dominance over the global economy for about 20 years from 1945 to about 1965. However, as the Vietnam War escalated, the US economy was somewhat diverted to the “guns” side of the “guns vs. butter” tradeoff, while the economies of Japan and Western Europe started to really get back on track.
Blowing sunshine in America
With Vietnam, the Great Society and a couple of oil shocks, a persistent but minor fiscal deficit began its metamorphosis into a significant structural problem. By the time the last of the celebratory champagne was drunk from Ronald Reagan’s trouncing of Walter Mondale, the deficit — the amount of money by which tax revenues lag expenditures — was running over $300 billion per year. And this was from a Republican President who, in 1980, railed against a Democratic one for running $60 billion a year in deficits.While the Laffer Curve has some very important insights into economic behavior, it ultimately represents a testable hypothesis, not an ironclad law. What’s more, it’s alleged test of lowering taxes rates in order to raise total tax revenue (something like a price elasticity for taxes) was conducted during a period of extreme Keynesian stimulus (e.g., the massive military buildup during Reagan). A couple of trillion dollars later, Reagan was effectively able to bankrupt the Soviet Union and its support network for its satellite countries, but before we could say, “peace dividend”, we were in the first of three successive wars in the Middle East.Of course, those of a Progressive leaning will want to offer up that during the Clinton presidency, the Federal Government ran a surplus. I suspect, in fact, that current politicians are looking at the Clinton-Gingrich showdown over the federal budget as a blueprint for the current debt ceiling fiasco. Unfortunately, actual data does not support the proposition of surpluses. Yes, Clinton did a LOT better than his immediate predecessors, but if you look at total borrowing, the national debt still increased each year under Clinton. Why the discrepancy?Much like when Regan’s economic team added the armed forces to the ranks of the employed, Clinton’s economic team included social security taxes as current taxes without recognizing any sort of long-term liability to offset the revenues. This would be the same as an insurance company taking in policy premiums for life insurance, but not booking any sort of expense against those revenues for the policies on which they expected to pay out. It may be great press, but it’s bad accounting.
Hitting the gas
With the bursting of the dotcom bubble, and related financial shenanigans, coincidental with the felling of the World Trade Center towers, and the subsequent wars in the Middle East, the US economy was effectively rescued from what should have been a massive recession and war-time footing by the Bush administration’s request to “go shopping”. With nominal deficits running $500 billion per year, a Republican administration again effectively pulled a page out of the Keynesian playbook, using large deficits to fund increases in government spending.
While Conservatives are quick to talk about the jobs created during Bush’s early years that coincided with decreases in marginal tax rates, they oddly seem to ignore that they did this without coming anywhere close to balancing the budget. It’s as if they think that saying “tax cuts creates jobs” enough times will make it true. Yes, there are ways to make tax cuts improve job growth, but blanket tax cuts aren’t it. You also need to cut spending by a like amount to make the Laffer Curve argument stick. That hasn’t been done — ever.
Instead, we have done the economic equivalent of “hitting the gas”. When the economy stopped responding to the existing stimulus (deficit), we just borrowed and spent even more. While this is good for near-term economic growth, it does so at the expense of long-term prospects (in economic terms, you are pulling demand forward). What’s even more interesting is that with the increased debt load, you add more risk into the economy since a greater proportion of income goes into debt service (i.e., interest payments). Where this truly goes astray is that with the greater risk, comes a greater requirement to ensure the economy continues growing. To continue growing the economy requires greater stimulus, and greater stimulus requires greater borrowing. In effect, what we have created, we, the voters, is a treadmill which is ever-increasing. Stopping will be painful, but the current “Great Recession” shows us just a taste of what life could be like once the treadmill breaks. We must responsibly slow things down…
Full faith and credit
If you’ve read this far, I thank you. The lack of basic economic literacy evidenced in the mass media appalls me. In the broader population, it is worse. I’ve spent a large number of paragraphs talking about the history of our debt, with only some tangential asides about why increasing the debt limit matters. Fundamentally, the issue with the United States government not being able to roll-over its debt and to increase its borrowings to meet its Congressionally-authorized (mandated) spending levels is two-fold:
First, is the damage it would do to global finance. As mentioned before, all of global finance rests on the idea of a risk-free rate of return. For good or ill, what bankers the world over have used for decades as a proxy for the risk-free rate are US Treasury Bills and Bonds. For these to come into question means a) finding an alternate risk-free asset, and b) re-pricing EVERY security based upon the new risk-free rate. This would be hugely tumultuous with credit markets seizing up while people tried to figure out which currency, asset or commodity might represent the best proxy for a riskless asset (Gold? The Euro? Oil? All seem to have upsides and downsides…).
Second, not raising the debt ceiling is the economic equivalent of “going cold turkey”. It is one way to break an addiction, but depending upon the drug and the depth of the addiction, the consequences of this can be worse, physiologically, than the addiction itself. Given the decades upon decades of deficit stimulus under which the US economy has been addicted, to remove such stimulus suddenly would not just invite recession, it would guarantee a significant depression. Imagine, people who had business built serving the federal government seeing their accounts receivable extended and order books slashed, people who rely on social security seeing their benefits cut, people whose businesses rely on either of those two markets see a softening of their business, etc. The primary effects would be bad enough, but macroeconomics is filled with the concept of a “multiplier” – the effects on secondary and tertiary markets away from the primary one. In other words, the ripple effects, as they are often called, would be more like tsunamis.
Not good.
Any one of these two primary effects would be disastrous enough. If one combines them, and multiplies them, then the result would be catastrophic. It would take us decades, as a global economy, to sort out the pieces. There would be winners, but there would be a lot of losers. Yes, we need to overhaul our spending priorities and taxation policy (less of the one, more of the other — pain for everyone), but we don’t need to do it in a way that threatens our economy so quickly after facing the brink of disaster. Please urge your congressman to do the right thing or do what the Founding Fathers intended and find another Congressman who will.
