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Emac's Bottom Line

Ban the Debt Limit

Should there be a debt limit at all? Moody's Investors Service doesn't think so.

In a new report that says the debt ceiling creates periodic uncertainty, Moody's drops this intriguing line: 


Moody's senior credit officer Steven Hess, who wrote the report, went on to say that "we think that the way the government handles the [debt] limit, particularly in times of divided government, is credit negative for the US." 

Translation: Moodys is asking the U.S. government to toss the limit, and instead have a framework based on the size of the total budget to keep borrowing in check. Can that work?

Not in an environment where the White House now calls the Republicans' "cut, cap and balance" bill arbitrary, in a statement saying "neither setting arbitrary spending levels nor amending the Constitution is necessary to restore fiscal responsibility."

Problem is, DC has also treated the debt ceiling as an "arbitrary spending level," raising it about 100 times since 1939. DC political dysfunction in high definition looks more like Italy with each passing day, which in turn means US Treasuries could look more and more like emerging market debt.

Last week both Moodys and Standard & Poors threatened to slash the U.S.s Triple-A rating down to double-A status if the government opted to default and did not pay interest on Treasuries, after blowing past the debt ceiling deadline Aug. 2d.

Both Moodys and Standard & Poors have said the debt ceiling is not the big issue. Its the size of the U.S. debt at more than $14 trillion, and paying the interest on the debt. That's what matters. Paying interest on the debt. If a country can't pay interest on its debt, then it's in default and it loses its rating. 

Interest costs on U.S. debt are about the size of Belgium at $413.9 billion. That figure includes interest on intra-government holdings in Social Security. Strip out those costs, and net interest on the U.S. debt is $197 billion or 9% of the $2.1 trillion in federal tax and other revenue. That's about what the U.S. government collects annually, $2.1 trillion, in federal tax and other revenue. It borrows the rest.

The ratings agencies seem to weigh net interest costs more, the $197 billion figure. Some insiders tell me if interest on the U.S. debt surpasses 15% of federal tax revenue, then that will set off alarm bells. Factor in Social Security, its already approaching 20%.

Which is why the President and the Democrats are talking about raising taxes, to pay that interest bill.

They tried to buy economic growth, but they gambled, they lost, and now they want you to pay for their bad bet. 

The Democrats tried to buy economic growth with $3.8 trillion in new spending, adding the equivalent of Germany and Russia to the US debt. 

Youve got to spend money to create money, to paraphrase Vice President Joe Biden. 

But joblessness has only grown, and US economic growth is flat lining at around 2%. That amounts to about $280 billion on a $14 trillion economy, just about enough to pay for interest on the debt.

Also, the $14.29 trillion figure doesnt include the budget busting cost of health reform, it doesn't include unfunded liabilities for Social Security and Medicare. Nor does it include the cost of U.S. conservatorship for housing finance companies Fannie Mae and Freddie Mac, at more than $5.5 trillion. Factor that debt in, and the US debt surpasses the gross domestic product of the planet, at more than $70 trillion. 

Economists Carmen Reinhart and Ken Rogoff have already reported that, historically, economies shrink as public debt exceeds 90% of GDP, as the government sucks more capital out of the markets to fund itself. 

The problem is, the U.S. historically has blunted the twin blade of the scissors to cut the deficit, a debt ceiling and a balanced budget amendment to the Constitution, which takes two-thirds of Congress and three-quarters of the states to pass. Congress has consistently been unable to pass a balanced budget amendment.

So that leaves the debt ceiling as one blade of the scissors. And when history repeats itself, things get more expensive, as the history of the debt ceiling fights proves.

The U.S. enacted the first ceiling on the national debt in 1917 as part of a law that ended a requirement that Congress approve every debt issue. President Woodrow Wilson then signed into law the Second Liberty Bond act of 1917.

Even at that time, elected officials knew they were making borrowing easier, as Congress was concerned about paying for World War I, says the Congressional Research Service [CRS].
The first ceiling was $8 billion over the prewar level of about $3 billion.

Sure enough, by the end of World War I, the government hiked the limit to $43 billion. For the first time, in 1939, Congress applied the limit to nearly all federal debt; by the end of World War II, the limit had risen to $300 billion, says CRS.

In the 1960s and 1970s, inflation and deficits grew hand-in-hand, CRS notes. In 1981, President Reagan signed the first debt ceiling that exceeded $1 trillion. Since then, the debt has grown faster than inflation. The most recent debt limit, enacted in February 2010, is $14.29 trillion.

Since 1939, the U.S. government has lifted the ceiling nearly 100 times. The Congress has raised the debt ceiling 11 times since 1996and, no surprise, for 14 consecutive years the Government Accountability Office says it could not sign off on the governments books because they are in such disarray.

In 1979 political fighting over the debt ceiling, and then a computer logjam, triggered a small technical default on about $110 million in short-dated bills, but interest rates did rise higher by about a third of a percentage point, until the U.S. cured the problem.

Breaking the debt ceiling deadline does not mean automatic default. The president in concert with the U.S. Congress and the Treasury Dept. would decide whether or not to pay interest on the U.S. debt in that event. The Bipartisan Policy Center, a DC think tank, says the government would immediately have to cut cash outlays by 45%.

In that event, all borrowing rates across the board would rise, and the repurchase market, or repo market, which exists for short-term liquidity and is built on U.S. Treasuries, would likely go into gridlock.

For now, the bond market has been quiescent due to investors achieving maximum escape velocity out of Euro zone debt, due to the fiscal crisis there, and into U.S. Treasuries. 

The Wall Street firm Blackrock says without this flight to safety, interest rates would be 25 points to 30 basis points higher. Keeping a lid on U.S. yields as well as is the deflationary environment in the U.S., as unemployment sticks adhesively above 9%. 

The nonchalant reaction in the bond market, and the way they are now priced, have led market watchers to note that few in the bond market believe the U.S. will default. Pointing to those low yields, government spenders have argued for even more spending.

However, during the last week of June, Treasury yields rose the most in nearly two years. The ten-year hit 3.2%, then dialed back.

Which is why the Federal Reserves purchases of about two thirds of new Treasury paper is an artificially dangerous move, as it makes the central bank the largest buyer right now of US debt and helps create a false, complacent spending atmosphere in Congress. 

And all this means U.S. Treasury Secretary Tim Geithner really cant complain about Europes failure to resolve its debt problems.

For now, it looks like the Republicans are setting the terms of the debate, with President Obama even threatening to ditch the Democrats at one point in the debt debate by agreeing to cuts of $4 trillion, only to move the goal posts back to around $1.5 trillion, which includes tax hikes, after high-level meetings with Democratic Congresswoman Nancy Pelosi and the progressive wing of his party.

House Republicans want $2.5 trillion without tax hikes. A Senate compromise would incorporate an idea by Sen. Mitch McConnell to let the president hike the debt ceiling by $2.5 trillion in three increments over 2012, an election year, whereby the president would veto any bill that would try to stop the debt ceiling increases.

The president needs that spending to support the U.S. economy as he faces re-election, because his faith-based initiatives to buy economic growth are vanishing. That includes a gargantuan $800 billion stimulus bill, about a third of which was tax cuts, more unemployment benefits, and federal help for the states, plus blowing out the U.S. balance sheet the size of Egypt for other stimulus items.

The debt ceiling fight should be a curb your enthusiasm moment, but still, the president and Democrats want even more spending. Economic policy is now consistent with the presidents re-election schedule.

At the same time, the White House continues to rely on overestimated GDP growth rates, causing flawed estimates for more spending plans to contaminate the debate.

And at the same time, the President is asking for a trillion dollars in new taxes over ten years, on top of the new taxes that will hit the middle class in his health reform bill, which are estimated at more than $450 billion.

President Obama needs a debt deal to seal his reputation as a centrist with independent voters, which make up 29% of the electorate.

And both sides want a deal that gives plausible deniability to make it look like they won more than they lost, as they walk the plank before their bases.

Ignored in all this is a bit of wisdom. No government should want the bond vigilantes enacting fiscal discipline for it. The bond markets takedown can be sudden, brutal, and violent. Which is why governments must enact fiscal discipline themselves.

The bond markets reaction to increased spending under Clinton Administration was swift and brutal. When the budget deficit increased under the Clinton Administration in the mid-90s, the bond market sold off. Bond yields about doubled in several years time to more than 8%.

The White House was forced to back off and instead balance the budget. That prompted James Carville, then an advisor to President Bill Clinton, to say: I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter.

Which is why the credit ratings agencies are watching. More closely than ever.

Think about this too.

Weve got an auto czar, a weatherization czar, even an Asian carp czar. But where is the deficit czar?

Isnt the deficit the most threatening danger of all, one that could hurt all of us, notably in our wallets?

Follow Elizabeth MacDonald on Twitter @LizMacDonaldFOX.