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Keep Raising the Debt Ceiling and the Whole House Will Collapse
By Chris Theobalt on January 30, 2012
I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared.
Last week on January 26th Congress voted against a measure to deprive the president of the authority to raise the debt ceiling. In a 44 – 52 vote, the president was granted permission to add another $1.2 trillion to the national debt, deferring for some time any difficult albeit necessary fiscal decisions. For the first time in over half a century, the national debt is roughly equal to the gross domestic product of the United States. This situation is analogous to an individual whose debts are equal to the total value of his income and savings. Mainstream economists will note, however, that this is not as dire of a situation as it first appears to be. After World War II, the national debt was 122 percent of GDP, about 22 percent higher than that of today. This is true, although there are several other factors that are worth consideration in comparing and contrasting the fiscal solvency of the United States in 1946 with that of today.
In the first place, the post WWII period in the United States was marked by massive spending cuts as the war ended. Many of the New Deal programs had been scaled back prior to this time in order to allocate revenue toward wartime expenses. Secondly, the reduction of New Deal regulation and spending, coupled with the removal of wartime regulations and spending freed up the economy, allowing for rapid economic growth and the absorption of millions of returning soldiers into the workforce. Americans witnessed a never before seen rise in their standard of living. The vibrancy of the postwar American economy, made possible by massive spending and regulatory cuts, provided a solid foundation upon which the national debt could be reduced to manageable levels. Furthermore, interest rates remained relatively low during this period, fluctuating between 1 and 2 percent. By the time interest rates finally rose (starting in 1970 and continuing through the early eighties) the national debt was less than half of GDP, making the cost of servicing the debt far less burdensome.
Now let us contrast the postwar situation with that of today. Our national debt is equal to GDP. Economic growth is exceptionally weak, and a host of new regulations and taxes are on the horizon. In addition, the current administration insists on spending as a means of spurring economic growth, a plan which has unambiguously failed to grow anything other than the national debt.
More importantly, interest rates are remaining historically low at about 0.25 percent. The threat of inflation is a laughable notion to most economists, although it should certainly not be discounted as such. As production dwindles in this country, and the monetary base expands indefinitely, inflation is inevitable and so will be the resulting spike in interest rates. The interest rate is a price, just like the price of milk or cell phones. The interest rate is the price of money, the price of capital. To attempt to manage it via central banking defies all economic logic. Most economists would agree that enacting a price control on milk, to set the price of milk lower than the market price, would result in a shortage of milk. The removal of the control would solve the shortage problem, but for a time milk would be more expensive than it was originally in order to ration the now diminished supply of milk. This principle applies to the interest rate. When Ben Bernanke suppresses the interest rate through inflation and “open market operations” he guarantees that there will be a shortage of capital. He can then do one of two things when this shortage becomes apparent: 1) He can allow rates to rise, which they must in order to compensate for the capital misallocation that resulted from the loose monetary policy currently being pursued. 2) He can continue to keep rates low by printing more money which will lead without fail to hyperinflation, the destruction of the dollar. The prospect of rising interest rates is not just speculative. It is a certainty that will have severe ramifications for our debt situation.
Another important factor to keep in mind is that the national debt was financed differently in 1946 than it is today. Government debt during and following WWII was typically financed with long – term bonds, meaning that even if interest rates had risen, the interest payments on the principal would not have increased. Today, much of our national debt is financed with short – term paper, meaning that a sudden spike in interest rates would cause the interest payments on our debt to increase once the temporarily low interest rate rolled over. This is eerily similar to the manner in which the mortgage market collapsed. Risky mortgages were financed by unqualified borrowers at adjustable rates, with the initial teaser rates being incredibly low. We all know how that ended. Rates rose to a point where borrowers could no longer afford their mortgage payments and the housing market collapsed. The same thing will happen to the Federal government if it does not soon abandon its reckless spending and monetary policies.
There is alarmist propaganda coming from both sides of the aisle, particularly from the left, alleging that a decision to not raise the debt ceiling would immediately lead to a United States default on its debts. What they fail to realize is that this default is unavoidable if the Federal government does not enact massive spending cuts and actually prove to its creditors that it is capable of paying back these loans. Our current policy of raising the debt ceiling to finance government spending and pay our creditors is analogous to an individual paying one credit card off with another. The only way to compel our politicians to do the right thing is by forcing them to deal with the prospect of default. If such action is not taken, it will only be a matter of time before our creditors cease to lend us money and default becomes a painful inevitability. Even worse is the possibility that politicians will try to avoid default by printing the money to pay off our debts, destroying the value of the dollar in the process.
We, as a nation, should avoid the temptation to approve the accumulation of more debt based on the misleading fact that after World War II our national debt was 122 percent of GDP. A closer analysis will reveal that the economic foundation of the United States was much sounder during that time than it is today. The only recourse for our current debt situation is to instill discipline in our government by disallowing increases in the debt ceiling and forcing dramatic spending cuts. This is the only possible way to avoid a sovereign debt crisis a là Greece and Italy or hyperinflation a là Zimbabwe.