Full Faith and Credit

As of yesterday, Congress has prevented the Treasury from raising enough money to pay for the laws Congress has passed.

Welcome to the debt ceiling: a funny law unique to the United States in which we prevent ourselves from paying our bills. Most nations worry about creditors losing faith and refusing to lend money. Not in America. We cut out the middleman.

Reducing the deficit is a noble cause and one that has to be addressed before long. But doing it with the debt ceiling is inane. If spending needs to be cut, cut spending. If taxes need to be raised, raise taxes. Tying the Treasury's hands and setting up a path to default solves nothing.

Some have said the Treasury can avoid default without raising the debt ceiling by prioritizing tax revenue, making interest payments while scaling back on all other expenditures until the budget balances. This sounds enticing until you look at the numbers.

The Treasury should take in $2.2 trillion in tax revenue this year. Spending on Medicare, Medicaid, Social Security, defense, and interest on the debt alone will cost $2.6 trillion. If every other arm of the government were eliminated entirely -- completely shut down Congress, the FBI, the IRS, Department of Energy, veterans' benefits, Department of Education, everything else -- there would still be a $400 billion deficit. To plug that hole, Medicare would have to be virtually eliminated, or a 60% cut to Social Security or defense spending would be in order. The Congressional Research Service gave more context earlier this year:

"If the debt limit is reached and Treasury is no longer able to issue federal debt, federal spending would have to be decreased or federal revenues would have to be increased by a corresponding amount to cover the gap in what cannot be borrowed. To put this into context, the federal government would have to eliminate all spending on discretionary programs, cut nearly 70% of outlays for mandatory programs, increase revenue collection by nearly two-thirds, or take some combination of those actions in the second half of FY2011."

Could that happen? Technically, yes. Realistically, no. Avoiding default without raising the debt ceiling assumes Congress can agree on how to cut more than $1 trillion in annual spending before August, when the Treasury says we'll be at default's door. But the reason we're having this debate is because they can't agree on how to cut a tiny, tiny fraction of that amount to begin with.

And this isn't just about Washington's inability to agree with each other. It's its willingness to please constituents. A recent Wall Street Journal/NBC poll shows less than a quarter of Americans support making significant cuts to entitlements in order to reduce the deficit -- a necessity to avoid default if the debt ceiling isn't raised. Another poll shows the majority of Americans don't think the debt ceiling should be raised, which highlights how disconnected many are on this issue. There's a widespread belief that the budget can be balanced without raising taxes or cutting entitlements and defense spending. It can't. Arithmetic always wins on this issue.

Raising the ceiling isn't anything new, by the way. The ceiling has been around in its current form since 1939, when it started with a cap of $45 billion for general debt and an additional $4 billion buffer for defense purposes. The fiscal needs of World War II blew those caps away, causing Congress to raise the ceiling more than sixfold, to $300 billion, by 1945. It's since been raised 87 times, an average of every nine months. The longest we've ever gone without raising the ceiling is five years, from 1997 to 2002. The fact that it's been raised so regularly under every partisan combination underlines how silly the debt ceiling is. Historically, it hasn't capped anything. It's just been something to vote on.

What happens if we do default? No one knows. It hasn't happened in modern history. Plenty of reputable economists say it'll bring havoc worse than the financial crisis of 2008. Others pooh-pooh the possibility, saying Treasury investors will welcome a shot at deficit reduction.

The latter seems delusional, akin to assuming Lehman Brothers' creditors should have welcomed news that defaulting mortgage loans cleansed its balance sheet. Equating a debt default to the chaos of 2008 may actually be a fair comparison. Back then, banks become insolvent as mortgage loans plunged in value. Today, banks like Citigroup (NYSE: C  ) , Bank of America (NYSE: BAC  ) , and JPMorgan Chase (NYSE: JPM  ) hold mountains of Treasury bonds that would plunge in value amid a default. Since the value of nearly every financial asset on earth is linked to Treasuries, markets would spiral. Don't take my word for it. Here's JPMorgan Chase CEO Jamie Dimon last month:

"Every single company with treasuries, every insurance fund ... it will start snowballing. Automatic, you don't pay your debt, there will be default by ratings agencies. All short-term financing will disappear."

None of this, again, absolves the need to address the budget deficit. Addressing it through default, though, is insane. It's self-destructive. Megalomaniacal. It sends a clear message to creditors: Don't invest your money here. We're too dysfunctional to handle it. So much for full faith and credit.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns Bank of America preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of JPMorgan Chase. The Fool owns shares of Bank of America and also holds a short position in the stock in a different portfolio. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (31)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 17, 2011, at 8:17 PM, Schono wrote:

    Why does this situation remind me of the scene in Blazing Saddles when Sheriff Bart (Cleavon Little) takes himself hostage?

    Bart: [low voice]Hold it! Next man makes a move, the [sheriff] gets it!

    Olson Johnson: Hold it, men. He's not bluffing.

    Dr. Sam Johnson: Listen to him, men. He's just crazy enough to do it!

    Bart: [low voice] Drop it! Or I swear I'll blow this [sheriff's] head all over this town!

    Bart: [high-pitched voice] Oh, lo'dy, lo'd, he's desp'it! Do what he sayyyy, do what he sayyyy!

  • Report this Comment On May 18, 2011, at 9:32 AM, mtf00l wrote:

    So everyone invested get's wiped out, all the other countries holding worthless U.S. paper get wiped out, whatever is left when the dust settles will be used to make the TBTF houses whole and the CEO's will get record bonuses.

    Lather, rinse, repeat.

    OR

    We become the North American Rebublic of China.

    Right...

    OR

    None of the above which is the most likely scenario.

  • Report this Comment On May 18, 2011, at 10:58 AM, Melaschasm wrote:

    The republican leadership is asking for a $1 spending cut for each $1 increase in the debt ceiling. In the highly unlikely event that the republicans get what they want, we are talking about an additional $500 billion in debt and $500 billing in spending cuts.

    However, the republican leadership always loses. Look at the $100 billion spending cut for the 2011 budget as an example. At most this was $20 billion in cuts, and I have heard reports that show a small increase in spending for 2011 over what Obama originally asked for.

    Best case scenario would be $200 billion in cuts and $800 billion in additional debt.

    A more likely result is $80 billion in cuts and $920 billion in additional debt. This would allow the republicans to make some minimal claim they kept the $100 billion dollar spending cut pledge.

    In other words, do not worry about the debt ceiling it is just a bunch of hoopla about nothing.

  • Report this Comment On May 18, 2011, at 12:21 PM, jkoo9 wrote:

    Mr. Housel is giving short shrift to the real issue, which is leveraging the raising of the debt ceiling to force free spending politicians on both sides of the aisle to agree to significant reductions in spending now, but more importantly, in the future. It should be plain that the conservatives will not let the U.S. default on its interest payments.

  • Report this Comment On May 19, 2011, at 4:30 PM, DJDynamicNC wrote:

    Actually, jkoo, that is not plain at all. Conservatives have shown an enduring willingness to risk the nation's future for short-term political gain.

    There are two nations currently residing with the borders of the United States. One of those nations is conservative, fundamentalist Christian, anti-science, pro-war, and morally bankrupt.

    The other one is America.

    I have great faith in our ability to triumph. After all, this has happened once before in American history, and we won that time too.

  • Report this Comment On May 19, 2011, at 4:32 PM, DJDynamicNC wrote:

    Oh, and for those truly worried about the deficit, simply allowing the Bush tax cuts to expire and ending subsidies to oil comanies pulling in record profits would basically end the short and medium term deficit problem.

    I recognize, however, that most Republicans are not actually concerned with the deficit whatsoever.

  • Report this Comment On May 19, 2011, at 7:35 PM, CaptainWidget wrote:

    You get into debt, eventually you have to cut up your credit cards. It doesn't matter how well intentioned you are with that credit card sitting in your drawer, poor spenders with an open line of credit will ALWAYS piss that money away.

    Just like every American who's ever cut up a credit card, strict budget constraints come afterwards. Trips to starbucks are cut LONG before rent payments. Federal subsidies to window makers will be cut long before social security payments and treasury bonds.

    To assume that congress won't be able to figure out essential vs non-essential payments in the absence of a open ended line of credit is crazy. Eventually the beast needs to be starved. It's the only way an accurate price signal will arise out of this situation. Marginal Utility will prevail in the presence of a finite amount of cashflow. The least important things will undoubtedly go first.

  • Report this Comment On May 20, 2011, at 2:15 AM, TMFDiogenes wrote:

    "Eventually the beast needs to be starved. It's the only way an accurate price signal will arise out of this situation. Marginal Utility will prevail in the presence of a finite amount of cashflow."

    I'll take supposedly "inaccurate price signals" over an economic depression any day.

  • Report this Comment On May 20, 2011, at 3:57 AM, CaptainWidget wrote:

    Well I won't. No offense, but this argument is ridiculous. One leads to the other. Innaccurate price signals lead to unsustainable growth. When price signals are poor and commodities (or the government in this case) manage to keep appreciating despite no underlying value add in the system, inflation drives up costs and increases production of the rotten commodity. When there's no negative price signal to say "this is too expensive", the rational action out of the market is to continue producing said good. Only when some forces steps forward to say "we can't afford this, prices need to drop" will prices (or more accurately, expenditures in this case) naturally correct. Trying to sustain growth with inflation inevitably leads to a crash, as everyone tries to grasp for resources simultaneously when they realize there aren't enough resources to go around.

    The only question is "do you want your medicine now or later?" Just like the person in massive credit card debt the solution is either

    A) Cut up those credit cards and make some hard decisions about what to cut out of your yearly budget, or

    B) Wait until people stop loaning you money, declare bankruptcy, and lose everything in one fell swoop

    Which one causes a worse economic depression? Bottom line, it's going to suck. The sooner they step up and make that hard decision, the less it's going to suck. You can't run 50 years of deficits without eventually paying the piper. And if you think the government is going to borrow their way out of their debt....well......I guess there's nothing more to say.

  • Report this Comment On May 20, 2011, at 9:44 AM, mtf00l wrote:

    This is a link to an article that links to this article;

    http://www.fool.com/investing/general/2011/05/18/where-all-t...

  • Report this Comment On May 20, 2011, at 11:40 AM, DJDynamicNC wrote:

    Equating the budget of the nation with a household budget is an appealing analogy, but a flawed one. You and I are unable to print our own money, for example. You and I are also unable to issue bonds which are extremely in demand across the planet, which would give us access to incredible financial reserves at very low rates.

    By contrast, the US government has both of these options available. We are more than able to finance our debt - the world is eager to buy our bonds, in fact - the only thing stopping us is an archaic law.

    Debt as a percentage of GDP remains quite low compared to historic levels - and as you'll recall, the last time we ran surpluses was because of modest tax increases coupled with modest spending cuts. Why aren't modest tax increases on the table? If you were serious about the deficit, you'd be willing to pony up an extra percent or two (especially considering we're currently at some of the lowest historical tax rates in history). That you are not is telling.

  • Report this Comment On May 20, 2011, at 11:46 AM, DJDynamicNC wrote:

    Bottom line - if deficits are a problem, then let's talk about a solution. The unwillingness of the ideologically inclined to discuss actual solutions is disappointing but unsurprising.

    Taxes were much higher during the 50s and 60s, which you may remember as being some of the longest and most consistent years of sustained prosperity in human history. I'm not advocating a return to 90% tax rates on the upper class (although I wouldn't be opposed to it), but clearly 28% isn't cutting it. Since implementing the tax cuts in 2001 and 2003, we have not seen a concurrent increase in growth, so clearly raising the tax rates wouldn't have a major effect on growth (since cutting them didn't in the slightest). So let's talk like adults about adult solutions instead of carping after ideological "starve the beast" platitudes. Trying to destroy the US government from within using financial idiocy isn't technically treason, but it sure as hell isn't patriotic.

  • Report this Comment On May 20, 2011, at 3:06 PM, mtf00l wrote:

    I'd like to see spending for the same period of time.

  • Report this Comment On May 20, 2011, at 4:04 PM, CaptainWidget wrote:

    <<Equating the budget of the nation with a household budget is an appealing analogy, but a flawed one.>>

    True. Like all analogies, it's not perfect. But it's more appealing than most people would like to think. The US government, in SOME form or another, is borrowing money from others in the full faith that it will pay it back.

    Printing money is simply devaluaing the US government's capital in the long term to pay off short term debt. Selling bonds is just a long term loan, and any individual can get a long term loan. The rates are the exceptional thing with the US government. On a scale of 1-850 FICO score, the US government has a 10,000.

    Although governments and individuals are fairly different, in the long run, they both have the balance their books. I don't think anyone questions that. The only question is HOW will the US government do that? It's either going to be eliminating their line of credit, coming to super-majority agreement in the legislative/executive branches that the US government should have a balanced budget (hahahahaha) or eventually defaulting. I'd love to see option 2 but let's be real.....it ain't going to happen.

  • Report this Comment On May 20, 2011, at 4:08 PM, CaptainWidget wrote:

    <<Taxes were much higher during the 50s and 60s, which you may remember as being some of the longest and most consistent years of sustained prosperity in human history>>

    The 50's were the flattest period of GDP growth since the great depression. Everything seemed great though because every other 1st world country was flattened at the time (leaving us the only country with productive capacity), labor was cheap, and oil was cheaper. Perfect storm for the market to be completely cleared of all our goods despite a high burden to productive labor. It wasn't until JFK lowered tax rates across the board that GDP actually started to increase again.

    I'd love to see tax reform, but only in the reform of "everyone pays the same flat rate".

  • Report this Comment On May 30, 2011, at 11:30 AM, Poppy113 wrote:

    DJDynamicNC seems to be suffering from some form of cognative dysfunction. The United States of America could have only come into existence from within a Judeo-Christian milieu. No one else has a sufficient epistemological base.

    Point Two, I'll be brief, History doesn't lie- increasing the debt limit and monetizeing our national debt to pay for it, is just plain stupid.

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