Remember these words: “means of extinguishment.” The full quote is “The creation of debt should always be accompanied with the means of extinguishment,” and it’s from Alexander Hamilton, the father of our national debt. Hamilton believed that the federal government could do the nation a big favor by carrying a debt as long as it had sufficient revenue streams to eventually pay it off; such an arrangement, he said, would give the US “immortal credit,” which could come in very handy whenever we had pressing needs or good public investment opportunities that justified borrowing more money.
This has been on my mind because the (yawn) “fiscal cliff” negotiations, whatever their outcome, are really just the latest round in an endless series of self-destructive battles over whether to honor our own budget commitments by raising the debt ceiling so that we can pay for them. I’ve written about Congress’s debt-ceiling looniness before, and how it would be better not to have such votes at all. Think the proposed budget has too big a deficit? Fine, then don’t vote for it. But to vote for it and then refuse to pay for it is not only cynical and hypocritical, but sows suspicion that the government is a deadbeat.
Standard & Poor’s (S&P) famously downgraded the federal government’s debt in August 2011 (from AAA to AA+), and the other two major bond rating agencies (Moody’s, Fitch) are threatening to do the same if Congress can’t reach some kind of agreement to reduce the debt/GDP ratio in the long term. After the subprime scandal, in which the rating agencies routinely rubber-stamped dodgy subprime mortgage-backed securities as AAA, these agencies have zero credibility, but that doesn’t mean they’re always wrong. The S&P said its downgrade “was pretty much motivated by all of the debate about the raising of the debt ceiling. . . . It involved a level of brinksmanship greater than what we had expected earlier in the year.” Yes — if Congress can’t be counted upon to honor its own commitments, which include paying back the principal and interest on previously issued Treasury bonds, then why should bond buyers regard Treasury bonds as completely safe? The more Congress continues to play these games, the more rational it is to conclude that maybe Treasury bonds are not so safe.
Another issue is the “means of extinguishment” of the debt. To repay a debt, you have to either pay for it out of your income or by issuing more debt (or some combination of the two. The Treasury also has the option of printing money, but that’s inflationary, so although that would eliminate the default risk, it would raise the risk of getting paid back in devalued dollars.) The standard measure of the debt is the publicly held debt as a percentage of GDP, under the assumption that any dollar in GDP could potentially be used toward paying off the debt. But that assumption fails if it’s impossible to raise taxes. With a majority of Republicans in Congress adamantly opposed to any tax increase whatsoever (as S&P noted in its 2011 report), the fact that the publicly held debt/GDP ratio is “only” 73% (high, but no higher than in the late 1940s) is a bit misleading. Having the potential revenue is one thing; being willing to use it is another.
To be sure, there’s no need to literally “extinguish” the debt. That hasn’t been done since the 1830s during the administration of Andrew Jackson, which was not exactly a model of enlightened economic policy. Historically in non-recession, non-war years, GDP grew faster than the debt, so the burden of debt (the debt/GDP ratio) fell. As long as the debt/GDP ratio is manageable, the budget need not be balanced, and the bond markets have felt that way for decades and still do — the current interest rate on 30-year Treasury bonds is under 3%, or about the lowest 30-year rate in the world.
But how much longer will the bond market feel that way? In two of the past three decades — the 1980s and the 2000s — the debt/GDP ratio went up even as the economy expanded, which would seem to reflect the tax-cutting priorities of Presidents Ronald Reagan and George W. Bush. (“Reagan proved deficits don’t matter” — Dick Cheney.) In the 1990s President Clinton pushed a tax increase through Congress, and the debt/GDP ratio fell sharply. President Obama would obviously like to raise the top tax rate right now from 35% to 39.6% (its Clinton-era level), but Republicans may be able to block that and, even if they can’t, raising taxes only on the rich does not raise all that much revenue, relative to the deficit. Most Americans think they’re overtaxed, even as actual tax burdens are at their lowest levels in decades. Meanwhile, the lingering Little Depression means our tax base is still below normal. Cutting spending is the other component of deficit reduction, but progress appears unlikely considering our huge monetary commitments in Iraq and Afghanistan, and the effect of rising health care costs on Medicare and Medicaid. It’s not hard to imagine the debt/GDP ratio staying above 70% for a long time to come. Which would be unprecedented — the last time it was that high, it fell to below 50% in less than a decade (the 1950s).
So far, the “bond vigilantes,”which are poised to demand a much higher risk premium and hence higher interest rates on Treasury bonds if the debt isn’t brought under control, are largely a figment of some people’s imagination. Paul Krugman and others have said they’re a phony threat cooked up by conservatives so as to force draconian cuts in social spending, and I tend to agree. But that doesn’t mean that they might not show up at some point. Having that “means of extinguishment” of the debt but being unwilling or unable to use it does not inspire confidence that debts will be repaid. It’s not hard to imagine Obama’s second term being consumed by repeated games of debt-ceiling chicken and increasing partisan polarization. If this goes on, and the debt/GDP stays high or even rises, then investors may decide that Treasury bonds are not such a safe bet, and Treasury rates could soar, compounding our debt problems even further.
Bond investors can reach that conclusion on their own; they don’t need the rating agencies to tell them that our government is dysfunctional . So far they’ve concluded that despite that dysfunction we’re still good for our debts. Regardless of what the ratings agencies do, the only downgrade that matters is the bond market’s, which thankfully hasn’t come yet. And now, in honor of the tenth anniversary of Joe Strummer’s death, here’s “the only band that matters”: