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Raising the U.S. Debt Ceiling: Much More Than A Slogan

The recent financial crisis and government's actions to recover from it have brought the workings of financial politics into the limelight like never before. Saturday Night Live spoofed the Secretary of the Treasury a while back -- when did so many people even know the treasury secretary's name?

Now headlines are full of the inside-Treasury-baseball issue of raising the federal debt ceiling. It's being held out as an important line in the sand for conservatives who want to cut government spending. There's no doubt that our lawmakers need to work hard to reshape government, but trying to take the bond market hostage by holding back on the debt ceiling won't accomplish anything, and by creating even a remote possibility of a default by the U.S. government could hurt America's financial standing in the world's markets.

Some background -- years ago, before World War I, Congress would approve big bond issues individually, but in 1917, they handed the management of federal debt over to the Treasury, while retaining control through a limit on total federal debt. A sound idea, of course. You wouldn't let a teenager set his own allowance.

Total federal debt outstanding was $14,183 billion on March 4, 2011. As of December 2010, debt was 92 percent of GDP -- a very high proportion. At current rates of borrowing and spending, the current debt limit of $14,294 billion will be reached sometime in May.

But the federal debt ceiling is a mechanical matter, not a philosophical one. Since the end of World War II, the federal debt ceiling has been raised 81 times -- more than once a year -- and decreased twice. Doctrines are more commonly brought to bear through the negotiations over spending bills, rather than tying the Treasury's hands.

Here's a graph of U.S. government debt relative to GDP since 1940. Borrowing shot up during World War II, and the proportion fell steadily until 1980, when it started to climb again sharply, during three Republican administrations (Reagan and Bush 41). It topped out in 1995, and fell for about five years only to pick up again during the Bush 43 years (there were surpluses in three years of the second Clinton administration). And, of course, debt has soared even more under the Obama administration, the consequence of holding the world economy together after the 2008 financial crisis. (The graph is from a recent report by the Congressional Research Service, which serves as a think-tank for Congress and writes on topics at lawmkers' request.)

Source: Congressional Research Service. Click to enlarge.
The U.S. government is a busy organization, and needs a constant flow of money to keep operating, and it's the Treasury's job to raise those funds, which it carries out mostly by issuing debt. Because the U.S. economy is the world's largest, its government bond market is the largest as well, and having a reliable system of issuance and repayment is what keeps government bond yields low. It's as essential to the federal government, and to the financial markets, as the water supply system to a big city. Placing an artificial limit on the amount flowing through, at a time that you need and have access to more, would be at best unhealthy and could be catastrophic.

While the eventual increase to the debt limit is essential, just as important is the political process that brings it about. Investors around the world need to know that our federal debt is sound, in that the Treasury is able to pay interest and principal on time.

So far the Treasury's cost of borrowing does not seem to be affected by the embarrassing political show. Yields on 10-year Treasury bonds, which is the Toyota Camry of the financial markets, have been under four percent since the financial crisis, and now stand at about 3.5 percent -- very low historical levels.

The market's assessment of the likelihood of a U.S. default is very low as well, as measured by the price of credit default swaps (CDS). Of the world's leading economies, the U.S. and Germany show the lowest prices for CDS, at 0.43 percent to insure a five-year bond on Friday, versus Germany at 0.44 percent. The U.K. is at 0.54 percent and France at 0.69 percent. U.S. bonds are still the safest thing around.

The global bond market sees through it all -- that the conservative ranting about spending and threatening to holding the country hostage are just noise, and that a higher debt limit will be in place at the last minute.

Both parties of Congress need to address cutting federal spending in a businesslike manner, and realize that they're not accomplishing anything with the cartoony doctrines. Please -- raise the debt ceiling, and then get on with the 10 or 20-year process we need of raising taxes and reducing spending to balance the federal budget in a rational way.

There is a little hope, in the form of the "Gang of Six," senators who have taken the initiative to work out a comprehensive budget plan. They see how serious the matter is -- from The New York Times:

...[Grover Norquist,] a Republican antitax activist, ...wrote to Mr. Chambliss, Mr. Coburn and Mr. Crapo to say they would violate his group's "Taxpayer Protection Pledge" if they supported raising revenues for deficit reduction.
The trio countered the same day, releasing a letter telling Mr. Norquist that their effort broke no pledge "but rather affirms the oath we have taken to support and defend the Constitution of the United States against all enemies, foreign and domestic, of which our national debt may now be the greatest."
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