Sometimes your kids pose questions that are impossible to answer.
My son recently had a doozy for me… “Why,” he asked, “does the debt ceiling exist?”
He’s a junior in high school and is taking a course on macroeconomics. This month they’re studying monetary and fiscal policy – interest rates, the Federal Reserve, taxation and government spending, etc. – and how they can impact the economy.
He’s had a bunch of questions for me about all of these topics, which is wonderful because I love talking about this stuff and it gives us yet another way to interact.
But he stumped me on the debt ceiling.
I’ve been monitoring this limit on U.S. borrowing for over a decade for various jobs, and it still doesn’t make any sense to me.
But apparently it doesn’t make sense to a lot of people…
When I was a consultant to hedge funds, I would make the rounds of European financial capitals – London, Madrid, Frankfurt, Geneva – to explain to them the intricacies and nuances of the Fed, the White House and the Treasury Department, as well as the politics of important committees on Capitol Hill.
In August 2011, I was in Frankfurt talking to hedge funds when the Obama administration and Congressional Republicans couldn’t agree to raise the limit on U.S. borrowing. The Treasury got perilously close to default.
And I would get the same question over and over: If Congress approved the spending and won’t raise taxes to pay for it, why would it then block the Treasury from borrowing the funds necessary to pay its bills?
Sure, I get the basic concept that the U.S. is far too indebted and continues to spend more than it takes in, year in and year out. As I write, the national debt stands at more than $31.5 trillion and counting (if you want to watch it rise, just check the U.S. Debt Clock – it’s not pretty).
But using the debt limit as a cudgel to try to force spending cuts has never really worked.
In fact, it has done a lot of damage.
In the 2011 episode, the Treasury Department had to take extraordinary measures to keep the government from defaulting on payments it was obligated to make. It got so close to a default that Standard & Poor’s downgraded the U.S. credit rating. And that triggered a massive sell-off of stocks. All three major indexes dropped between 5% and 7% in a day, and credit markets went haywire.
The General Accounting Office estimated that the crisis, by sending Treasury yields higher, cost the U.S. $1.3 billion extra in borrowing costs that year and close to $19 billion over the following years.
What Happens if We Default?
So here we are again. Republicans in Congress are demanding spending cuts in exchange for raising the debt ceiling.
Luckily, we’ve got a few months – likely until summer – for them to figure it out and come to an agreement.
And don’t get me wrong, spending cuts are necessary. Figuring out where to make them is the hard part.
Keep in mind that more than 60% of all federal government spending – “mandatory” spending – is on extremely popular programs like Social Security and Medicare.
Another 30% or so – “discretionary” spending – is dominated by defense spending, which is also popular within both political parties.
And the rest goes to interest on our massive debt. That absolutely has to be paid.
So defense, healthcare and debt. One witty budget analyst I used to consult would always say that if you squint, the U.S. budget resembles that of an army with a huge health plan and a massive credit card balance.
If Congress and the White House can’t agree on how to raise the limit by summer, causing the U.S. to stop payments on some of its thousands of daily obligations, the unthinkable would happen: default.
It’s so unthinkable that threatening it doesn’t make any sense. I’ve seen some ridiculous financial media articles about how to prepare for a default, or what investors should do in the event of a default.
If the U.S. defaults on its debt, forget about your portfolio and your bank account and start thinking about storing gasoline and ammunition in your backyard, because the world financial system will collapse. A new dark age will ensue.
But it won’t happen, thankfully. The debt limit has been raised or suspended more than 100 times since World War II. It was most recently raised in late 2021, to more than $31 trillion.
That’s another reason this whole drama surrounding the limit is absurd. Because we all know the outcome.
Let’s find another way to balance the budget – one that doesn’t cost more money and send the stock market plummeting. I’ll discuss this in my article next week.