Monday, August 01, 2011

What's a "Debt Ceiling" and What's all the Recent Hoopla Surrounding It?

(Somewhere in a suburban middle class house....)

Son: Dad, you busy?

Dad: I was just watching “Lord of the Rings”, son. Come on in.

Son: Wow, you’re really obsessed with these movies.

Dad: I’m not obsessed. I just happen to enjoy artistic movies with cool special effects. Now what’s on your mind, Legolas?

Son: In school and in the news, they keep talking about this “debt ceiling” thing and how we’re all in deep doo-doo if it isn’t dealt with right. So what’s a debt ceiling and what’s all the hoopla over it?

Dad: Wouldn’t you rather have a talk about sex? Okay - well quite simply, our federal debt ceiling is the maximum limit of how much money our country can borrow and owe at any given time.

Son: Kind of like a credit card limit?

Dad: Yes, kind of. You can’t go over a credit card limit unless you get permission from the credit card company. In the case of the US, the US Treasury has to ask Congress for permission each time it wants to spend above the debt ceiling. Per this analogy, Congress is the Visa-issuing bank, and the US Treasury is your mother. Of course, your mother can always use her American Express or Discover Card when her Visa limit is reached. The US Treasury has just the one “card”, if you will.

Son: So who’s loaning the money?

Dad: Our federal government borrows money from two main sources. One is the public, which includes you, me, and the People’s Republic of China. The other is from government accounts like Social Security, Medicare, and transportation trust funds. These are sometimes called intragovernmental debt. The sum of public and intragovernmental borrowings make up our country’s total debt.

Son: I also keep hearing about the federal deficit. Aren’t deficit and debt the same thing?

Dad: No no, they’re different things, but they’re related. A deficit is the amount of money spent that is higher than the amount taken in. So if our family earns $100,000 this year and spends $120,000, our deficit this year would be $20,000 (and if your mom finds another “sale” at Macy’s, our deficit could be several times that). The total debt is simply what is owed in total; every deficit adds to the total debt, and every surplus (when income exceeds spending) reduces it. Continuing the above example, if the total family debt we owe at the beginning of the year is $200,000 and we had “deficit spending” of $20,000 over the next twelve months, our total debt is $220,000 at the end of the year. So our federal deficit is just the amount the government spends that exceeds the amount of revenue it gets in the form of taxes and fees.

Son: So going back to total debt, why have a debt ceiling? Sounds like it’s more trouble than it’s worth. Can’t we just trust the government to spend prudently?

Dad: Ha ha! Hack….sorry son, allergies. No, it’s probably wise to have a spending cap to ensure fiscal responsibility. We didn’t always have this though. It wasn’t until 1917 when Congress enacted the first statutory limit on federal debt. The US was about to enter World War I and the government needed money, so Congress allowed the US Treasury some freedom to raise money, specifically to issue long term Liberty Bonds. Previously, the US Treasury was by and large only allowed to borrow shorter term loans or ask Congress permission to get loans for specific purposes, like help build the Panama Canal. So basically Congress said, “Okay Treasury. Here’s more freedom for you to raise money so we may take advantage of market conditions and better interest rates. However, you can’t exceed this pre-specified cap unless we give you specific permission.”

Son: My understanding is that the current hoopla has to do with Congress’ reluctance to raise this cap. I guess raising the debt ceiling is a rare occurrence?

Dad: On the contrary, I believe the debt ceiling has been raised over a hundred times since it commenced, and 74 times since 1962.

Son: So what’s all the controversy about now?

Dad: A big reason for the current hoopla is that the US total debt level is at a historic high. When the debt ceiling was first implemented, the cap was $11.5 billion. Today, it’s at $14.3 trillion, or about 1,200 times higher. Perhaps more importantly, the US federal debt level as a percentage of US Gross Domestic Product is also close to historic highs. There have only been two times in history when the federal debt level has exceeded the annual GDP. The first was during World War II; the second is now, in the wake of our 2008 economic crash. With the “Great Recession” of 2008-2009 and subsequent anemic GDP growth, combined with increased spending due to attempts at boosting the economy, paying for a couple of wars, among other reasons, you can easily see why we’re in this situation. Now why is this important? Again, for demonstration purposes here’s a rather simplistic analogy: if our family is earning $100,000 a year, and we have total credit card debt of $20,000, our financial situation wouldn't be ideal but it’s likely we can comfortably handle things over the long run. However, if our income is suddenly reduced to $90,000 a year, and our total credit card debt owed reaches say $95,000, this could be cause for concern, especially if (a) there’s no clear indication our income will rise significantly anytime soon, and (b) our record debt level was hit not because your dad succumbed to his mid-life crisis and purchased a Ferrari, but because we’re simply paying for our everyday “normal” expenses. In order to reduce or eliminate the debt, we either have to dramatically increase our income, or reduce our expenses, and preferably both.

Son: But what do the politicians have to do with this?

Dad: Well, raising the debt ceiling requires Congressional approval, i.e. both the Senate and House of Representatives have to approve. Since the Republican elephants control the House and the Democrat donkeys control the Senate, you have stalemate unless both sides reach compromise. Not surprisingly, both sides will always try to move fiscal policy toward their own respective ideologies, as well as utilize situations like our current one for political gain. That we’re coming up on an election year is only exacerbating the battle.

Son: So who are the bad guys in all this?

Dad: Son, unlike fantasy movies like Lord of the Rings or Star Wars, there is no clear good and bad. Real life is closer to documentaries like The Godfather..."good" and "bad" really depends on your point of view. Depending on who you ask, Nancy Pelosi or John Boehner can both be the most despicable orc or the most gallant elf (although in John’s case he’d inevitably be the orc or elf with the nicest tan). When you come right down to it, both sides in this debate are being true to their respective ideologies and are fawning the constituents responsible for voting them into office and helping re-elect them later. The Republicans always prefer to reduce the “house-hold” spend, which they feel is excessive and out of control, while the Democrats would rather focus on increasing income so programs they feel are important don’t get cut. There are pros and cons to both arguments, and if you turn on any of the cable news channels you'll hear every one of these points until your ears bleed. Where you fall on the spectrum depends on your personal, political, and economic philosophies. In the end, the resolution to this debt ceiling crisis will likely be a compromise that will piss everybody off but will be grudgingly deemed barely acceptable by both sides.

Son: But what if they don’t reach a compromise and the debt ceiling isn’t raised on time?

Dad: Well, in essence that would mean the US cannot pay all of its bills, because it doesn’t have enough available cash on hand and won’t be able to borrow the cash it needs to pay everything in full. Keep in mind that this has never occurred before; the US has always paid all its bills on time, which is why US bonds are considered the safest investment in the world. Some current projections suggest that if the debt ceiling isn’t raised, the US would not be able to pay about 44% of its monthly bill, or about $134 billion. If that happens, US Treasury bonds would lose its AAA credit rating and the interest rate the US would be required to pay on debt would in all likelihood go up. This of course would further add to the financial woes. The dynamic is similar to a person not paying his credit card minimum on time, which would lower his credit rating, which in turn would cause this and all other credit cards to raise his required interest rate. Additionally, it’s possible that an unprecedented US default on debt could cause the US economy to fall back into recession, and the stock market to tank significantly. In conclusion, it would be bad jujus all around. Logic suggests that despite all their partisan rhetoric, the politicians would not allow this to happen.

Son: But I thought you told me that logic and politicians go together like logic and a Kevin James movie?

Father: Well that's true son. But allowing a US default would run counter to the politicians' primary goal of preserving the seats of their pants, as well as their congressional seats.

Son: Thanks for the explanation Dad. Speaking of the US economy, can you explain the nuances of supply-side economics and trickle-down theory?

Dad: Later son. I hear your mother calling us for dinner, and it’s not wise to keep Saruman waiting.

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