Tuesday, August 2, 2011

Debt limit and federal default: What they are and what they mean to you

As the deadline for an agreement on raising the debt ceiling approaches on August 2, it remains to be seen whether the Democrats and Republicans in Congress can reach a compromise that will allow the federal government to continue to meet its obligations. Many Americans do not understand the background of the debt limit debate. Many others don’t believe that it will have an impact on them.

The debt limit is the congressionally imposed limit on borrowing. According to Factcheck.org, the federal government is currently borrowing thirty-six cents for every dollar that it spends. Part of the problem is that tax revenues have fallen since the onset of the recession in 2008, while federal spending has increased. When the federal government reaches the limit of what Congress allows it to borrow, it will have to begin choosing what bills to pay and which ones to default on.

The situation is similar to that of many families in Atlanta, around Georgia and throughout the country that were financing a plush lifestyle with mortgages and credit cards before the recession started. The breadwinners in the family took pay cuts, like many others in the country, but imagine that in this case, rather than cutting back on spending when they realized that they were bringing home less money, they started borrowing more in an attempt to preserve their old lifestyle. In fact, with the huge increases in federal spending, it is like the family took a pay cut and then went out and bought a new luxury car on credit. Everything that they used to pay cash for, the family now charges to their credit cards. The hope is that if they can borrow until more money starts coming in and avoid making painful spending cuts entirely.

The problem is that there are consequences to excessive borrowing. The federal debt limit is analogous to the family’s credit limit. The family, like the federal government, cannot borrow indefinitely. Sooner or later, the overspending family will max out their credit cards. As their debt increases, it will get harder to find places to borrow more money and the interest rate for their borrowing will increase because loans to this family will be considered more and more risky for the lender. Eventually they will be forced to stop borrowing and make cuts to their spending when they are not able to borrow any more money.

At this point, the federal government has refused to make meaningful spending cuts and is seeking to raise the credit limit on its old credit card and apply for new ones. One price that the government might pay for running up the balance on its credit cards even higher is a downgrade to the United State bond ratings.

U.S. treasury bonds are currently rated AAA and are considered the safest investment in the world, but massive increases in federal debt and spending have led rating agencies to warn that they may have to downgrade the rating on U.S. bonds. This is akin to the hypothetical family’s credit score being downgraded from 700 to 600. It means that interest rates will be higher for future bond sales which will increase the cost of government borrowing. It also means that unless changes are made, further downgrades could come soon.

It is likely that the federal debt limit will be raised, but that won’t solve the federal government’s problem. The fundamental problem is that the government spends much more than it receives in taxes. Like a family with a pay cut, the federal government faces two options. First, it can cut spending and live within its means. The problem with this option is that federal spending is made up of popular but expensive programs. Any attempt to cut any federal program meets with resistance from voters and activists. It is like facing opposition from mother for cuts to the grocery budget. Brother doesn’t want to spend less on video games while sister needs her clothing allowance. Father doesn’t want to eliminate cable television from the family budget.

A second option is find a way to increase the money coming in. For the family, that means finding a job that pays more or working a second job. For Congress, it would mean raising taxes. The problem with this option is that, just as most Americans can’t find a higher-paying job, they also can’t afford to pay higher taxes without further damaging the economy.

Ironically, the Laffer Curve, an economic principle, shows that beyond a certain point even an increase in taxes won’t generate more tax revenues. As tax rates increase, so much money is leaving the private economy and going to the government that it discourages investment and production. Consequently, tax revenues fall and the government collects less money. Even if the government can generate some additional tax revenue by raising taxes, the government’s spending problem is so large that it cannot be solved without spending cuts.

If Congress fails to raise the debt limit, the government will not be broke because some tax money will be coming in; it just won’t be enough to pay everything. The government will have to choose which bills to pay and which ones to defer until it has more money, just as many families have to choose which bills to pay. Theoretically, the government could pay important bills, like Social Security payments and military salaries, while delaying payment on less important things like Senator Harry Reid’s cowboy poetry festival and the thousands of other wasteful items in the federal budget. In the final analysis, practically everything the government spends money on, especially the big-ticket items like Medicaid, Medicare, Social Security, and defense, will have to be reconsidered and restructured, but that is a long-term problem.

In the short term, the effect of a default would depend on what Treasury Secretary Tim Geithner and President Obama decide to stop paying. They could choose to stop making Social Security payments to increase pressure on Republicans. They could divert money from defense and other federal departments to keep social spending active. Many government employees might be laid off.

Companies that do business with the federal government would likely not receive payments. That might mean that workers at these companies would be laid off or go unpaid. The uncertainty in the economy could cause the stock market to crash.

Georgia and other states might not receive federal grants and subsidies which would mean tighter states budgets and more layoffs for state employees. Many of these states, like Georgia, have already made painful cuts to state government budgets and experienced rounds of layoffs rather than financing their spending with more debt. Unlike the federal government, thirty-seven states have balanced budget laws that do not allow a deficit to be carried forward according to the National Conference of State Legislatures. Georgia does not have such a law.

If the U.S. bond rating is downgraded, interest rates will likely rise on treasury bonds. The increase in interest rates will ripple through the economy. Interest rates will rise on everything from mortgages to credit cards. Borrowing will be more expensive for American companies and consumers as well as the government.

The ultimate outcome of the battles over spending, taxes and the federal debt remain to be seen. What is obvious is that the U.S. is on an unsustainable course. The failures of national economies such as Greece are a warning to Americans that reckless spending cannot be financed with borrowing indefinitely without doing serious damage to the nation.

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