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.
