What's the big deal about the debt ceiling?

This piece should scare you.  It was written by a top notch economist, in plain language. I urge you to read it http://economix.blogs.nytimes.com/2013/10/03/the-loss-of-u-s-pre-eminence/?_r=0.   It in part answers some of the questions I have been hearing lately that pretty much all can be summed up as, “What’s the big deal about the debt ceiling?”

The debt ceiling is the United States Government’s limit on the amount of debt the Treasury Department is legally allowed to issue.  Think of it as the limit on your credit card, but the consequences of exceeding it are much more dire. Among other things, this debt is accrued interest on amounts already borrowed and payments due for money Congress already authorized and appropriated for spending.  To not allow an increase to the debt ceiling is tantamount to being told you could buy something, but when the bill comes not given the money to do so.

The blog included above points out the current fiscal and political environments are sowing the seeds for the decline of the US from its pre-eminent position economically.  Economics is weird.  Is it a science or an art? Is it mathematics and statistics or psychology?  The basis for all economics is the idea of utility; how much an individual wants something.  Utility explains why gold costs more than silver, Coke costs more than Kroger cola and someone is willing to spend $5,000 on Prada; yet pretty much all sugar costs the same.  We as consumers, all things being equal, assign intrinsic values to items based on perception and past performance; and are willing to pay more for items with intrinsic value.  Without utility, advertisers would not have a job.  This phenomenon is the basis for everything we purchase.

Utility plays a role in currency and sovereign debt.  At different points in the recent past, up to 90% of global financial transactions passed through the US, daily.  The United States dollar is the most well respected piece of currency in the world, therefore gets used all over the world.  It is the confidence in the United States economy (not necessarily Government) that accounts for use of the US Dollar, and purchase of US debt.  Without this confidence, the US will have to pay more through higher interest rates.  Recent examples of this are the lack luster performance of debt issuances by Ireland, Spain, Greece and Malta.  A sharp increase in the cost of issuing debt will immediately drain funds from the US economy and begin hyperinflation like that seen in Mexico and Venezuela.  Albert Einstein once said the greatest power in the universe is compound debt.

As for the global economy, simply look to the reaction to defaults by Greece and Malta.  Greece caused a recession in the entire Eurozone, and some experts believe muted growth of both the US and Chinese economies due to the reduction of imports to the Eurozone.  Malta, a very small island nation, almost caused another recession in the Eurozone.  The US Economy is magnitudes of order greater than either Greece or Malta.  The results of a US default would also be magnitudes of order greater.  Too big to fail?  Definitely!

The silence from industry as discussed in the blog above is a warning.  Regardless of personal opinion on Obamacare, Keystone XL or changes to the tax code, Congress and the president CANNOT let this happen.  It’s not a question of whether or not there will be a global recession if the US defaults.  It’s only a question of how severe.  And when the dust settles, the US may no longer be at the top of the heap.

Where is the fiscal policy?

Governments can affect the economy in two main ways: fiscal policy or monetary policy.  The most successful economies stem from governance where these two are in sync, or at least not counterproductive.  An example of monetary policy is the Federal Reserve Board’s Quantitative Easing, or QE.  Examples of fiscal policy are austerity programs implemented in the European Union.  Faced with a global economic downturn, contrary to other major economic powers the US Government chose to flood the market with capital rather than pursue austerity.  As a result, the US Economy has fared better than our European brethren; so much so that the United Kingdom has begun QE as well.  Now, though, the effectiveness of QE has begun to wane, and many are wondering why.

Why haven’t there been larger reductions in unemployment? Why are corporations holding onto excessive amounts of capital rather than investing? Why has consumer confidence only seen modest gains? Why has housing begun to level off after some modest gains? The only truly bright spot has been the growth in the stock market, which has as much to do with profitability as QE, and falters the minute the Fed begins to indicate an easing of QE.

The short answer to all of these questions, the absence of fiscal policy has been counterproductive to the point where the monetary policy may begin to harm the economy.  The ineptitude in Congress creates uncertainty for producers, consumers, investors, lenders and borrowers.  Come 01 October 2013, Congress will not have passed a budget for the fourth year in a row.  This is their main job!  Some in Congress are threatening a Government shutdown.  Even if there is a Continuing Resolution, the Government will only be funded two and a half months instead of the full year.  Some in Congress are threatening the full faith and credit of the US Government by not raising the debt ceiling. While Government spending is related to the debt ceiling, the debt ceiling is for money that has already been spent.

Consumer spending and business investment drive the US Economy.  Businesses are not investing because demand has not returned.  Consumers are not spending to protect themselves from the uncertainty coming out of Washington, and mortgage rates which have increased in no small part due to the potential of a US Government default.  Investors are shying away from the bond market for fear their investments will be undercut by a Government default.  All of this slows the velocity of money, and with it the economy as a whole.  Without decisive action from Washington, the US Economy is stuck in the chicken vs. egg paradox.

Not only has the lack of fiscal policy caused its own harm to the US Economy, but now it is causing harm to monetary policy and the credibility of the Fed itself.  After signaling an impending taper to QE, the Fed decided to keep the program in place.  In large part, the reason for this change is an attempt to push past the chicken vs. egg paradox. 

Unfortunately, monetary policy cannot do this on its own.  And what is worse, as the Dallas Federal Reserve Bank President Richard Fisher correctly points out, this turnabout degrades the credibility of communications coming from the Fed. To compound matters, Mr. Bernanke’s impending retirement creates uncertainty for monetary policy.  No disrespect to the candidates vying to succeed him, but markets dislike change.

Without decisive fiscal policy, monetary policy will become less and less effective at stimulating the economy.