The Federal Government of these United States of America is partially closed down. Congress is divided against itself: the Republican-controlled House of Representatives can't agree with the Democrat-controller Senate on how to reopen.
More ominous, all pundits agree, is that the national debt will hit the debt ceiling sometime soon, with October 17, 2013 frequently given as an estimate. Since the federal government continues to run a budget deficit, its debt is increasing. The ceiling is $16.7 trillion.
The debt ceiling is artificial in the sense that it is legislated by Congress (and signed into law by the President). It can be raised or lowered by Congress. Those who believe the national debt is not a problem (or, misinterpreting Alexander Hamilton and John Maynard Keynes, is actually an asset) might want to just abolish the ceiling, or set at at $30 trillion and forget it for a couple of years.
There is a real debt ceiling, however. It does not have a definite number on it, but it is real enough.
Consider, as an analogy, propeller-driven airplanes. Each model of airplane has a ceiling, because air thins are you climb to higher elevations. The better designed and lighter the airplane and the more powerful its thrust (from the engine and propeller system), the higher the ceiling. But at some point every airplane stalls: its propeller cannot push enough air to give enough thrust to get it higher.
Likewise where the real debt ceiling is for the federal government of the United States depends on a variety of factors. For instance, if the government could raise more in taxes (by raising rates or because of an expanding economy), it would have a higher ceiling than if revenue from taxes fell.
If the federal government offers higher interest rates (which are set at auction), then investors should be willing to loan more money to it.
Investors, in fact, are the key actors. There are all sorts of investors who buy federal debt. Since the Great Recession began they have accepted very low rates of interest. More investors might buy federal debt if interest rates on the debt were higher.
But no matter how high interest rates go, there is still a ceiling. Even a loan shark charging interest (at perhaps 100% per year) to the federal government would stop loaning if it became clear that the loan could not be repaid. And who's going to break the legs of the federal government?
If the annual interest on the federal debt begins approach a high share of annual federal revenues, the federal government would go into a Death Spiral. Say the interest reached one-half, or 50% of annual revenues. Policy makers would have three basic choices. They could prioritize interest payments by cutting federal spending. But that would hurt the economy, resulting in lower tax collections the following year, plus there would be political fallout from the many Americans who depend on federal spending.
A second choice when interest on the debt reaches 50% of annual revenue would be to increase taxes so that spending could be maintained along with interest payments. The problem with that is that such taxes would have to be broadly based. The economy would go into a depression, lowering tax collections.
A combination of cutting spending and raising taxes might work today, but would just cause a depression if we wait until interest hits 50% of revenue.
A third choice is to simply let the debt balloon. But as the debt balloons, the interest would also balloon. Interest rates would have to go even higher. The necessity for defaulting on, or writing down, the debt would be obvious. The debt would quickly hit the real debt ceiling, but that would not stop the death spiral. If 50% of federal revenue were assigned to just pay the interest, it would not be enough. Bonds (federal debt) come due at intervals: the principle would have to be repaid. Just to replace the bonds would require higher interest rates, so the interest would soon consume 51% of revenue, then 52%, and on up to 100% of revenue.
Clearly the three choices above would lead to the end of the United States as we know it. A fourth possibility would be allowing inflation to reduce the real value of the debt. Long-term bond holders would just have to eat their losses. But even this would not likely work because it also would hurt the economy so badly that we would have a depression, which would be deflationary, defeating the purpose of allowing goods and services to inflate in dollar value.
The real debt ceiling is likely somewhere between where we are now and where the interest on the debt reaches 50% of federal revenue. Federal revenue in fiscal 2013 was budgeted at $2.9 trillion. 50% of that would be $1.45 trillion. If the average interest on federal debt rises to 5% (a conservative figure, but above what the feds paid during the recession), the debt ceiling in the scenario above would be 29 trillion dollars. Way above the current legal limit.
But if investors lose confidence in the federal government (which they should have by now) and the interest on the debt rose to an average of 10% (admittedly higher than it has been yet), the scenario of the death spiral would occur at $14.5 trillion dollars.
That is right. A death spiral is possible, if enough investors lose confidence, at below the current $16.7 trillion debt limit.
So where the real debt limit lies depends on where real investors, as a group, draw the line.
It would be interesting to ask a few people like Janet Yellen, Ben Bernanke, Lawrence Summers, Barack Obama, Jacob Lew and John Boehner exactly what they think the real debt limit is.
Even the GAO thinks "Debt held by the public at these high levels could limit the federal government's flexibility to address emerging issues and unforeseen challenges such as another economic downturn or large-scale natural disaster. Furthermore, in both the Baseline Extended and Alternative simulations, debt held by the public continues to grow as a share of GDP in the coming decades, indicating that the federal government remains on an unsustainable long-term fiscal path." [GAO Long Term Outlook]
I predict we are in for stormy fiscal weather. Today the government pays interest at a rate from practically zero on short term notes to 3.75% on 30 year bonds. I believe the Federal Reserve has gone to great lengths to keep interest rates low not just because that encourages an economic recovery, but because it puts off the day of reckoning on the real cost of the national debt.
The Republicans are right, we need to cut spending. But we have to cut spending in a way that minimized the hurt to both people and the economy. That means cutting subsidies to the rich, the upper middle class, and in particular military spending and foreign aid. But the Republicans want to cut payments for seniors and the poor.
The Democrats are right, we need more revenue, which means more taxes. We need a higher tax rate on people earning more than $50 million per year and on large inheritances. We need to close every loophole. We need to legalize and tax "street" drugs. But tax increases do result in less spending and less capital deployment, so they should be reasonable. And the Democrats, too, have been reluctant to cut military spending.
The American economy has been badly hurt by both parties and both branches of Congress and by the President these past few years. By protecting their turfs, including the Pentagon budget, they are weakening the long-term viability of the United States.
Both parties should agree to balance the budget in fiscal 2015 and start paying down the national debt in fiscal 2016. The pain will be shared by everyone, but to the extent it can be targeted by law, it should be dished out to those who have benefited most from the American economy.