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The Debt Ceiling: What’s Different This Time and Why?

| July 27, 2011
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You may be too busy stocking up on bottled water and ammunition right now to watch cable news, but CNN’s current graphic is: “Countdown to U.S. Default.” (Actually, they just changed it to “Amy Winehouse Albums Sales Surge.” But you get the point.)

The situation: If the U.S. doesn’t raise by Aug 2 (or thereabouts) the amount of debt it is legally allowed to carry from the current paltry $14.3 trillion, the country won’t have enough money to pay both the interest to bond holders and all the other stuff the government is responsible for, like Social Security payments.

A lot of things are different this time around.

The debt ceiling has been raised many times in recent history, but mostly with little fanfare — at least compared to what we are seeing today.

I talked to Alan Auerbach, professor of economics and law and director of the Robert D. Burch Center for Tax Policy and Public Finance at UC Berkeley, about what makes this time different. He explained, among other things, the reasons for the debt-limit stalemate, just how much debt the U.S. is currently carrying in historical terms, and why markets have been yawning (though this seems to be changing) at the potential unprecedented event.

Here’s what he had to say. (Audio for each section is followed by an edited transcript.)

Prof Auberbach explains the debt ceiling

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What is the debt ceiling?

The debt ceiling is a limit on the amount of debt the US goverment can have outstanding. When it is approached by the debt that government issues, Congress has to pass a bill to raise it.

This happens all the time. In recent decades, it’s happened many times in each administration, because the national debt keeps going up, sometimes more slowly, sometimes rapidly. Each time Congress raises the debt ceiling they choose a new number to raise it to, and as long as the government proceeds without hitting that ceiling, it doesn’t come into play.

But as the ceiling is approached again, Congress has to pass a new bill to raise it. And frequently when the debt ceiling is approached, they take that opportunity to talk about the policies the government is following, and usually the party out of power makes some complaints. But this is really the first time in my memory that we have this kind of crisis associated with the debt ceiling.

We’ve had other crises associated with the federal budget. Just this winter, President Obama and congress had to agree to an extension of certain tax provisions, stimulus provisions, in order to get a budget passed.

But without an increase in the debt ceiling, we’ve been told, by Aug 2, the national debt limit will have been hit. At that point there will have to be a reduction in spending to avoid an increase in debt and a default on the outstanding debt.

On the reasons for the crisis and the size of the debt historically

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Sounds like its never been an issue to this extent before…

It’s been an issue, but I don’t think we’ve ever confronted this kind of possible default or calamity so close to the deadline. It’s certainly been raised as an issue before. The party that’s out of of power has some leverage to make complaints about what the government’s doing, and perhaps even to extract some promises or changes in policy. But we’re talking about very major possible changes in policy that would be needed, at least under some scenarios in order to get the debt limit passed.

Has the crisis emanated from the fact that Republicans are trying to extract much greater changes in policy than normally would be the case from a party out of power?

A lot of things are different this time around. The Republicans have a new contingent generally associated with the Tea Party, very large, particularly well-represented among members who were elected for the first time in 2010, who are taking a very strong position on this issue. Indeed, some of them have said they won’t vote to raise the debt limit under any circumstances. More of them have said they’d only vote to raise the limit only in conjunction with very substantial cuts in spending and in both cases with no tax increases.

In addition we’ve had a very rapid increase in the national debt in the last few years. It increased fairly rapidly during the George W. Bush administration, and largely as a result of the recession, it’s risen even more rapidly in the last couple of years. People are much more aware of the size of the national debt now than has been true in the past. So there’s probably some very large political content to it, but the situation also reflects changes in the status of the national debt.

How great is the country’s debt now in historic terms?

The debt limit actually applies to the gross federal debt, which is all the debt that the goverment has issued. But a lot of that economists generally don’t count because a substantial amount of that is held, for example, by the Social Security trust funds, and that’s essentially one element of government holding debt issued by another.

We usually like to focus on the debt held by the public, which is now about 10 trillion dollars. And that’s about 2/3 of gross domestic product. That’s not nearly as high as it was at the end of WW II, when it was close to 110%. But the main difference is that at that point, the war was over, and we knew we didn’t have very large deficits in the future to add to the total debt. Now, we don’t’ simply have a debt that’s grown very rapidly in recent years relative to the size of the economy, we also have very large deficits projected for the immediate term and after. So the issue is not simply where we are now, but it’s where we expect to be in the relatively near future if we don’t take some sort of action.

How much higher is the debt now than it was during the Reagan years?

The national debt relative to GDP is higher now than it was then. It rose during the Reagan years, it rose again relative to the economy during the George W. Bush years. It fell relative to the economy starting at the end of the first George Bush administration and throughout the Clinton administration. It’s been fluctuating but rising very rapidly in recent years, to a very large extent because the recession we had was much more serious than any since the Great Depression.

When we have such a serious recession, our tax revenues fall off very sharply, and we also have to engage in certain kinds of spending to try to keep the economy going. And those add quite appreciably to an annual deficit. We’ve been running deficits of close to 10% of GDP a year, which are unprecedented peacetime deficits for the US.

I think it’s how rapidly the debt has grown in the last few years that has spooked a lot of people.

On the lack of reaction so far by financial markets

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The S&P 500 is actually up over the past month. Markets do not seem to be reacting yet to the deadline. How do you account for that?

Well, I think they think a deal is going to be worked out. A lot of people in the markets are wondering what it all means. They understand if the US government really lets the debate go and doesn’t come to an agreement and we hit the ceiling and have to stop issuing debt then it’s a very serious matter. I think the people who are determining prices in markets feel that this is too serious an issue for the government not to deal with.

They may be wrong. The markets are often wrong, but in this case that seems to be what people believe.

Have we seen any effects on markets yet?

We haven’t really seen effects in terms of an appreciable increase in interest rates. What you’d expect to see if people were really worrying about the ability of the government to make its interest payments, in light of the threatened downgrade by the rating agencies for example, is a sharp increases in the interest rates of treasury securities. They’ve been bouncing up and down but we haven’t seen any precipitous increases.

On what happens if there is no deal by the deadline?

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Okay, worst case scenario, we wake up August 2 and the limit has not been raised. What happens?

I think it depends on how close we are to an agreement. There’s an analogy to labor negotiations, where you often have a deadline on paper. But very often if they’re close to an agreement, they’ll essentially stop the clock and say we need 12 hours more or we need 24 hours more and we’re just going to put everything on hold till then.

If President Obama and leaders in Congress are at that stage on August 2, I don’t think anything really important will happen as a result. Payments can be deferred for 24 hours by the government to vendors and others. Nobody will really notice.

On the other hand, if August 2 comes and they’re no closer to an agreement than they are right now, that’s more serious. Because that suggests legislation won’t be a matter of days but perhaps weeks or months.

And of course the government can’t get by for that long by just asking people to wait for their checks. At that point the government would have to start making very large cuts in spending programs because they don’t really have any other choice.

Of course they could default on the national debt but one guesses they wouldn’t do that first. Its not clear legally exactly what choices they have in terms of what payments to make first, but they’d have to cut something.

On whether the average citizen should be worried

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Should the average citizen be worried about this?

The average citizen has a lot of things to worry about. Given the unemployment rate, they’re probably pretty worried about their jobs; those who are working may have incomes that haven’t kept up with the cost of living.

I think the debt limit is a pretty abstract concept. In normal times, a more responsible government would be able to keep it that way and not make it something that the average citizen would have to worry about. One would hope that this is an anomalous situation and that they’ll come to an agreement and average citizens can go on worrying about the things that are are directly of more concern to them.

 

Also, the other day, KQED’s Peter Jon Shuler talked to Paul McIntosh, Executive Director of the California State Association of Counties, to discuss the potential fallout to local governments should the feds not get their act together in time.

Here’s that conversation:

Paul McIntosh, of California Association of Counties, on potential local fallout from debt-limit crisis

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What are we looking at in terms of impact on counties?

It’s a bit speculative, it depends on how long the impasse would last. The most immediate impact would be if ratings agencies dropped the federal credit rating. That could have some dramatic impacts on interest rates that our counties may have to pay on bonds they may want to issue.

If the federal cash flow becomes an issue, that would have a dramatic impact on payments back to the state and to our counties for many of the health and human services programs we operate on behalf of the state and federal governments. We’d be in a very, very dire cash-flow situation ourselves.

What kinds of things do you count on the federal government for?

Food stamps, Medicaid, Cal Works, child welfare services, child support services, a whole wide variety of health and human services that the federal government participates in. And they’re the majority participant in most of those programs.

What preparations have counties made?

The state treasurer borrowed five billion to cover cash flow, going directly to banks as opposed to issuing bonds, which would have put the state at risk from the federal interest rate credit market. Most of our counties have already done that. I’m aware of a couple that have not, and they could have problems.

What could happen?
They probably wouldn’t’ be able to issue bonds, because the margin between the cost of issuance and the value of issuing is very slim, so anything that tipped that scale that would erase that margin. So it wouldn’t be in their best interest to issue the bonds.

So they would just have to wait it out?

They would suffer a cash flow crunch over the course of the year.

What are you doing in terms of this debate, and what are the counties doing about it?

We’ve communicated to our delegation in Washington DC. Our emphasis is on resolving this issue in a balanced manner.

And what are you hearing back from them?

We haven”t had any comment back.

 

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