The debt limit is the world’s highest-stakes horoscope: Not raising the debt limit would guarantee a recession
U.S. Treasury Secretary Janet Yellen announced last week that the federal government had reached the statutory debt limit and that her department had begun “extraordinary measures” to meet required spending obligations. It is estimated that by July these extraordinary measures will no longer be able to keep some spending obligations from being missed.
The fact that the statutory debt limit can inject such chaos into the American political system and economy is truly odd. The debt limit measures nothing coherent and has no relationship to any serious measure of the economic burden imposed by the nation’s debt. It has as much relevance to the nation’s objective economic health as today’s horoscope. Yet if it’s allowed to bind, disaster would result. And if the price of convincing House Republicans to raise the debt limit is large cuts to federal spending, this still ensures grave damage to the economy and vulnerable families.
The debt limit—and particularly its relationship to the objective economic facts of the nation’s fiscal health—is poorly understood by too many. In this post, we make the following points about the debt limit in the current moment:
- A recession is guaranteed if the debt limit is not raised. This wound to the U.S. economy would be inflicted entirely by the irresponsibility of the Republican caucus in the House of Representatives.
- “Reprioritization” of spending in the face of a binding debt limit—or paying some obligations of the federal government in full while inflicting much steeper cuts on other obligations—does not change the fact that a recession would result. In fact, if “reprioritization” privileges holders of U.S. debt over other spending obligations, it could make the recession worse.
- The debt limit measures no coherent economic value. Given the stakes involved, many assume that the debt limit must be some meaningful parameter that plays an important role in maintaining the fiscal health and sustainability of the federal government. This is false. The debt limit is essentially an exercise in numerology.
- The value of what it measures—the nominal dollar level of outstanding gross public debt—has zero relationship to the economic fundamentals of the nation’s fiscal health. The debt limit is not inflation-adjusted, measures debt the government owes itself, does not include federal government assets, and is completely uncorrelated with genuine measures of fiscal health (like the debt service ratio—or interest payments on government debt divided by national income).
- A deal with spending cuts does not avoid the debt limit’s damage. Given the damage that would be done by allowing the debt limit to bind, some might think that any deal to raise it would be worth doing. But this is not right either. Deals that include steep spending cuts would also carry a high risk of causing a recession. The entire danger posed by the debt limit is that damaging spending cuts might be caused by an absurd political institution. Embracing spending cuts (even not as steep) simply to avoid the absurd political institution cannot be a serious answer.
- A debt ceiling deal that included steep budget cuts was almost the entire reason why the economic recovery from the 2008–09 recession was the slowest in post-war history.
- The debt limit should be abolished—either formally or effectively. If Congress will not raise the debt limit without a damaging deal on spending, the Biden administration should pursue work-arounds—including potentially minting a trillion-dollar coin—to keep the debt limit from binding.
The U.S. Treasury draws on banking accounts at the Federal Reserve to fund federal governmental activities—remitting paychecks to federal government employees, sending Social Security checks, paying U.S. bondholders, reimbursing medical providers for services covered by Medicare and Medicaid, and so on. These accounts are fed on an ongoing basis by both tax revenues and the proceeds from selling bonds (debt). But since the United States has a statutorily imposed limit of how much outstanding debt is allowed, once this limit is reached on issuing new debt, Treasury can no longer sell bonds and deposit these proceeds. As a result, accounts at the Federal Reserve will dwindle as they are now only fed by incoming taxes, which are insufficient to cover all spending. If Congress does not raise the debt limit, the Biden administration does not enact any work-around, and federal spending is indeed forced to contract to a level that can be financed only by taxes, then the debt limit will “bind” spending.
Consequences of allowing the debt limit to bind spending
The U.S. is currently borrowing an amount roughly equal to 4% of gross domestic product (GDP) to finance spending. If no new borrowing was allowed due to the debt limit, this means that spending would have to fall by 4% of GDP. A spending cut of 4% of GDP is a mammoth shock, and to have it slam into the economy suddenly would be spectacularly damaging.
For comparison, the abrupt swing from borrowing to saving—known as private-sector “deleveraging”—that led to the Great Recession in 2008–2009 was about a 9% share of GDP, but that was spread over more than two years. This means that the mechanical shutdown of spending caused by hitting the debt ceiling would be about the same annualized size—but would occur even more suddenly—as the one that led to the Great Recession.
Even worse, as the negative fiscal shock rippled through the private economy, the austerity would become self-reinforcing. Say that in the first month, the 4% of GDP cutback in federal spending has a multiplier of 1, so economic activity in that month is slowed by 4% of that month’s GDP in total. (While it’s true that multiplier effects may well not happen right away, illustratively this is the dynamic we’re facing.) With GDP and incomes 4% lower, tax collections will fall by roughly 1% of GDP. So the next month, not only will the original cutback in spending occur, but lower tax collections will ratchet down spending even more—and pretty quickly!
Normally, the federal budget acts as an automatic stabilizer when recessions hit—taxes fall and spending rises and debt increases, all of which spurs economic activity. But a recession caused by an arbitrary legal rule that spending cannot exceed (falling) taxes means that the budget would actually act as an automatic destabilizer.
If the spending cutbacks occur for a month, say, and then federal transfers make up for the lost month, then much of the damage could be undone pretty quickly. But not all of it. Take the example of retirees who do not go out to eat in their local diners for a month because their Social Security checks do not arrive. If the Social Security checks start coming later and retirees return to diners—and even if the previous missed payments are made up—this does not restore the lost income to wait staff who missed a month of customers.
Finally, these are just the “mechanical” effects of hitting the debt ceiling. The ripple effects stemming from distress in financial markets that would be sparked by missing interest payments on Treasury bonds could be extreme as well. But these mechanical effects are useful to keep in mind when some misleadingly claim that Treasury can “reprioritize” payments to bondholders and hence the United States can avoid technical “default.” Prioritizing interest payments to bondholders just means defaulting even more heavily on Social Security beneficiaries, doctors’ reimbursements for seeing Medicare and Medicaid patients, federal contractors’ bills, safety net spending, and all other federal payments.
“Reprioritizing” some payments over others does not change the grim mechanical arithmetic run through above—and might make it worse. Bondholders are a relatively rich group, and much of the U.S. federal debt is held by other countries. Both of these things mean that cuts to bondholders would result in less of a spending pullback than equivalent cuts to vulnerable families. In short, “reprioritization” is default by another name, and one that makes the economic damage of allowing the debt limit to bind even greater.
The debt limit is numerology
The statutory debt ceiling is a completely arbitrary value—there is no compelling economic justification for its historical values and it is raised (or suspended periodically) purely based on congressional whim and partisan political strategizing. The absurdities in using the nominal value of gross federal debt as a high-stakes economic indicator are abundant.
For example, the debt limit is not indexed for inflation, even as many federal government payments and taxes are indexed (either implicitly or explicitly). Further, the debt limit measures gross debt, which includes debt the federal government owes itself. The biggest difference between the debt held by public and gross debt is the Social Security Trust Fund (SSTF). To help pre-fund the now-arrived retirement of the Baby Boomer generation, for years the Social Security system taxed current workers more than what was needed to pay current beneficiaries. The surplus was credited to the SSTF. As dedicated Social Security revenues fall a bit short of benefits in coming decades, the system (as designed) will draw down the SSTF. But this means that as the SSTF rose—as the Social Security system ran a surplus—measures of gross debt were actually inflated. How can that make sense?
The gross debt also excludes the roughly $2 trillion in financial assets (mostly student loans) held by the federal government. Any measure that aims to measure the balance sheet health of an entity probably shouldn’t ignore trillions of dollars in assets.
Sometimes the debt limit is defended as a useful measure to make Congress pause and be mindful about the nation’s fiscal situation. But this argument is absurd. For one, a measure meant to enforce mindfulness should not be so high stakes and subject to political opportunism. If the debt limit just forced a day of congressional debate whenever it was breached rather than forcing a sudden contraction of federal spending, this argument might make more sense. Most importantly, a prompt forcing Congress to pause and think about the nation’s fiscal health should have some empirical relationship to the nation’s fiscal health. The debt limit does not.
Given the measurement absurdities noted above, it is no surprise that the debt ceiling does not correlate at all with meaningful measures of the burden imposed by the nation’s debt. Probably the most meaningful measure of this burden is interest payments on the debt expressed as a share of GDP. This debt service ratio and the nominal value of the nation’s outstanding public debt (what triggers the debt limit) are almost entirely uncorrelated.
For example, in 1996, gross federal debt stood at $5.2 trillion. By 2019, it was at $22.7 trillion. Yet in 1996, debt service payments—the interest costs needed to be paid on outstanding debt—were 3.0% of GDP, but by 2019 they were just 1.8%. Since 2019, this debt service ratio has declined even further as nominal debt rose by another $8 trillion. The reason why interest rates have collapsed while debt has grown is simply that both variables have been driven by pronounced economic weakness over most of the post-2000 period. But the larger point is that the level of gross federal debt has no reliable relationship to any economic stressor faced by governments or households, so hinging something as high stakes as a hard limit on the federal government’s legal ability to borrow on this measure makes no sense.
A deal with spending cuts does not avoid the debt limit’s damage
People often invoke the damage done by the 2011 showdown over the debt ceiling. But they often miss what was by far the greatest damage done by the 2011 debt ceiling episode: the passage of the Budget Control Act (BCA), a piece of legislation that is relatively unknown to the lay public, but that delivered an anti-stimulus to the U.S. economy about two times as powerful as the stimulus provided by the Obama administration’s Recovery Act in 2009.
The BCA’s caps on federal spending explain a large part of why this spending in the aftermath of the Great Recession was the slowest in history following any recession (or at least since the Great Depression). If this spending had instead followed the normal post-recession path, then a return to pre-recession unemployment rates would’ve happened 5-6 years before it finally did in 2017.
The BCA was the GOP demand for raising the debt limit in 2011, and the Obama administration acquiesced to it. The leverage provided by the debt limit led directly to the worst recovery following a recession since World War II. This leverage the debt ceiling provides to those looking to enforce austerity is its greatest—and often most-overlooked—danger.
The debt limit needs to be abolished—either formally or effectively
Given all of this, it is obvious that the U.S. should join the vast majority of rich countries around the world who do not have a statutory debt limit. It would be most straightforward if Congress abolished it, but that is extremely unlikely in the near term.
For now, if Congress will not act sensibly and raise the debt limit without a damaging deal on spending, the Biden administration should act in any way it can to keep the debt limit from binding. The most fun proposed executive work-around—one that highlights the sheer stupidity of the debt limit—is minting a trillion-dollar platinum coin. If that somehow sounds not serious enough, other work-arounds certainly seem plausible as well. But it should be remembered that the least serious outcome is the one that causes the most damage: letting a wholly baseless bit of numerology—and not the needs of the American people—determine what the nation is allowed to spend.
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