In our last Reality Check, we discussed that there are many important differences between government debt and personal debt and why the analogy between the family budget and the government budget is false in so many ways. Today, we will discuss the debt ceiling and the idea of the balanced budget amendment and paying off our debt. Politicians of all stripes, from Republicans to centrist Democrats, love these ideas because it allow them to have it both ways - sounding like they are being fiscally responsible while doing business as usual.
The debt ceiling is a self-imposed limit that Congress puts on US Treasury that restricts the amount the Treasury can borrow to pay its existing legal obligations. The important part of the prior statement is "existing legal obligations". In other words, Congress has already approved and authorized the US Treasury to spend this money, knowing full well that the artificial ceiling on borrowing they have set will be breached. A useful analogy to our own lives would be agreeing to a mortgage of $100,000 and then saying that you've decided you can only have $80,000 of mortgage debt - if only things were that easy. Now, the politicians could easily ensure that the debt limit was not reached by making sure the budgets they pass would not lead to borrowing that will exceed the very debt limit that they themselves have imposed. But the debt ceiling, a purely political construct, allows Congress to increase spending or cut taxes which mandates that the Treasury breach the debt limit. Then those same members of Congress can rail against the debt, or, as we have seen lately, use raising the debt ceiling as a bargaining chip to accomplish some other political goal. And, other than some on the political extremes, the idea of defaulting on the debt and breaking the full faith and credit of the US Government is a non-starter - it would be a financial calamity for us and for the global economy. One other important point - most other countries do not have a debt ceiling; it appears that the US is the only major industrialized country that has a debt ceiling. So, the next time we run up against the debt ceiling and politicians start posturing about our debt, remember that these same politicians have already authorized the borrowing that they are complaining about.
Another classic political posture is the idea of a balanced budget amendment that requires the federal budget be balanced every year as well as paying off our national debt. Put aside for the moment the difficulty in getting an amendment like this passed - Republicans would be afraid of tax increases Democrats would propose when in power; similarly, Democrats would fear the spending cuts Republicans would offer; or the fact that traditional economic theory says that we may need to run deficits in times of war or during economic downturns; or that much of the increased annual deficit during a recession is caused by "automatic stabilizers" like unemployment insurance or food stamps. All that aside, the biggest obstacle would be the objections of Wall Street and the global financial community, because a constantly balanced US budget with no debt would be an economic disaster for the US and the global economy. Now, this may seem counterintuitive, that the financial community would be opposed to a balanced budget, but it's true and we saw it happen less than 20 years ago.
It might surprise you to know that the US was actually running annual budget surpluses and was even paying down its debt as recently as the late 1990s - in fact, in fiscal year 2000, the annual budget surplus was over $235 billion. And in that same fiscal year, we reduced our total debt by over $100 billion. Because of the surplus, the US Treasury could retire, rather than roll over, some debt as it matured, and the amount of new debt that needed to be issued also decreased. Now you would think that this would make the fiscal scolds on Wall Street happy, but, in fact, it was the exact opposite. There was a genuine fear that the entire US debt could be eliminated and the reasons for that fear are outlined in this September, 2000 paper from the New York Fed. The key takeaway from the paper is as follows:
In other words, there are a significant number of segments of not only Wall Street, but also of the US and global economy that rely on a steady flow of highly liquid and risk-free US Government securities in order to work smoothly and efficiently. Since the US Dollar is essentially the reserve currency of the world, central bankers and the global financial community rely on a steady supply of those same highly liquid and risk-free securities as in indicator for the risk-free interest rate but also for the liquidity to support the global economy. And the "shadow banking system", especially the markets for repurchase agreements, rely on these very same securities to keep the cost of short term borrowing down not only for financial institutions but also for business here in the US and elsewhere. Having worked on a repo desk at that time, I know there was great anxiety about the possibility of not having enough US debt to fuel an efficient repo market and the only viable replacement for that debt would be high grade Corporate bonds whose borrowing costs would be significantly higher due to the possibility of default. That is what I mean when I say that US Government debt, in the form of US Treasury securities, is what greases the wheels of our global economy.
And this anxiety extended to the Federal Reserve who worried that the elimination of the debt would force it into using those same Corporate bonds in their efforts to influence interest rates. As Alan Greenspan, who at the time was an almost god-like figure as Chairman of the Federal Reserve, testified in a 2001 Senate hearing:
"Continuing to run surpluses beyond the point at which we reach zero or near-zero federal debt brings to center stage the critical longer term policy issue of whether the federal government should accumulate large quantities of private -- more technically, nonfederal -- assets. At zero debt, the continuing unified budget surpluses currently projected imply a major accumulation of private assets by the federal government."
Another classic political posture is the idea of a balanced budget amendment that requires the federal budget be balanced every year as well as paying off our national debt. Put aside for the moment the difficulty in getting an amendment like this passed - Republicans would be afraid of tax increases Democrats would propose when in power; similarly, Democrats would fear the spending cuts Republicans would offer; or the fact that traditional economic theory says that we may need to run deficits in times of war or during economic downturns; or that much of the increased annual deficit during a recession is caused by "automatic stabilizers" like unemployment insurance or food stamps. All that aside, the biggest obstacle would be the objections of Wall Street and the global financial community, because a constantly balanced US budget with no debt would be an economic disaster for the US and the global economy. Now, this may seem counterintuitive, that the financial community would be opposed to a balanced budget, but it's true and we saw it happen less than 20 years ago.
It might surprise you to know that the US was actually running annual budget surpluses and was even paying down its debt as recently as the late 1990s - in fact, in fiscal year 2000, the annual budget surplus was over $235 billion. And in that same fiscal year, we reduced our total debt by over $100 billion. Because of the surplus, the US Treasury could retire, rather than roll over, some debt as it matured, and the amount of new debt that needed to be issued also decreased. Now you would think that this would make the fiscal scolds on Wall Street happy, but, in fact, it was the exact opposite. There was a genuine fear that the entire US debt could be eliminated and the reasons for that fear are outlined in this September, 2000 paper from the New York Fed. The key takeaway from the paper is as follows:
As Treasury securities are free
from default risk and highly liquid across a wide range of issues, the
securities are a benchmark for risk-free interest rates. Well-developed
derivatives markets that enable investors to sell Treasuries short combine with
the securities' liquidity and creditworthiness to make them a reference and
hedging benchmark for other fixed-income securities. Due to their
creditworthiness and liquidity, Treasury securities are a popular reserve asset
to numerous financial institutions and the primary asset of the Federal
Reserve.
The paper argues that many of the
features that make the U.S. Treasury market an attractive benchmark and reserve
asset are likely to be adversely affected by the debt paydown. In fact, recent
events are suggestive of reduced Treasury supply disrupting the market and may
be indicative of future disruptions. In February 2000, for example, the
Treasury announced that the issuance frequency of the one-year bill would be
reduced from every four weeks to every 13 weeks. As the last bill auctioned on
the old cycle aged, it became very expensive to borrow in the repurchase
agreement (RP or repo) market. On May 31, for instance, a dealer had to lend
out funds at a 2.25% annual rate in order to secure the one year bill as collateral.
The liquidity of the issue in the cash market also suffered, with bid-ask
spreads widening and trading volume plunging. At the same time, the issue
became extremely expensive relative to other Treasuries with similar maturities
and relative to similar maturity non-Treasury instruments.
In other words, there are a significant number of segments of not only Wall Street, but also of the US and global economy that rely on a steady flow of highly liquid and risk-free US Government securities in order to work smoothly and efficiently. Since the US Dollar is essentially the reserve currency of the world, central bankers and the global financial community rely on a steady supply of those same highly liquid and risk-free securities as in indicator for the risk-free interest rate but also for the liquidity to support the global economy. And the "shadow banking system", especially the markets for repurchase agreements, rely on these very same securities to keep the cost of short term borrowing down not only for financial institutions but also for business here in the US and elsewhere. Having worked on a repo desk at that time, I know there was great anxiety about the possibility of not having enough US debt to fuel an efficient repo market and the only viable replacement for that debt would be high grade Corporate bonds whose borrowing costs would be significantly higher due to the possibility of default. That is what I mean when I say that US Government debt, in the form of US Treasury securities, is what greases the wheels of our global economy.
And this anxiety extended to the Federal Reserve who worried that the elimination of the debt would force it into using those same Corporate bonds in their efforts to influence interest rates. As Alan Greenspan, who at the time was an almost god-like figure as Chairman of the Federal Reserve, testified in a 2001 Senate hearing:
"Continuing to run surpluses beyond the point at which we reach zero or near-zero federal debt brings to center stage the critical longer term policy issue of whether the federal government should accumulate large quantities of private -- more technically, nonfederal -- assets. At zero debt, the continuing unified budget surpluses currently projected imply a major accumulation of private assets by the federal government."
In other words, he opposed the idea of paying down our national debt, ostensibly because he did not want to the Federal Reserve to be the buyer or seller of private corporate debt in order to fulfill its mandate to control interest rates. And his stand provided the cover needed to pass the Bush tax cuts and removed the possibility of eliminating the national debt, much to the relief of the financial community worldwide. Those tax cuts, along with the bursting of the dot-com bubble, and the September 11th attacks took us from an annual budget surplus of over $235 billion in fiscal year 2000 to an annual deficit of over $375 billion in FY 2003. So any time you hear a politician propose a balanced budget and paying down our national debt, the biggest opponents to actual implementation of those ideas will be Wall Street and the global financial community. They may pay lip service to those ideas in principle but, when those ideas look like they might actually become a reality, they will oppose them. They've opposed them in the past and they will oppose them again in the future - that's just a fact.
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