Still Living Dangerously With a Debt Ceiling

As part of a bipartisan deal on July 25, 2019, the House of Representatives passed legislation to raise the debt ceiling, as it has done more than 60 times before. (The Senate was expected to pass the bill Wednesday or Thursday.) It's good that we have averted a crisis, but this obscures the fact that Congress keeps laying tripwire for itself that causes ongoing problems for investors and raises the cost of borrowing. In short, the debt-ceiling system is a relic, does not force fiscal responsibility, and might one day trigger a major financial crisis.

Before World War I, every time the federal government needed to borrow more money, Congress approved the debt issuance. During the war, instead of Congress approving new bonds for the war effort, it told the Treasury to just borrow what it needed for different types of debt instruments, up to a limit, and come back and get permission if it needed to borrow more. Later, in 1941, Congress further streamlined the debt ceiling to include all government debt under one limit.

This system makes pretty good sense in the context of an unexpected war. If it seemed like financing the fighting was getting too expensive to put on the national balance sheet, Congress could cut off more spending and borrowing or raise taxes. The key is that Congress would decide on a spending policy and a borrowing policy at the same time.

The problem with the debt limit today is that it is not related in any way to the spending Congress authorizes. That means as we approach the debt limit every few years, Congress has given the Treasury three conflicting instructions: cut checks for bridges, roads, fighter jets, and the like, collect less in tax revenue than those things cost, but do not borrow to cover the difference.

If Congress keeps setting this tripwire every few years, we will keep running the risk that because of malice or incompetence Congress will stumble over it someday, greatly damaging the world economy.

The U.S. Treasury puts it simply: "Failing to increase the debt limit would have catastrophic economic consequences." If the United States defaulted on its obligations, market participants would not know how to value the Treasury bills and notes that make up the backbone of the U.S. and global financial system, leading to chaos, since market participants generally consider these assets to be riskless. Because the Treasury has not wanted to encourage Congress to breach the debt ceiling, it does not have any (public at least) plan to cope with competing directives from Congress, guaranteeing maximum chaos. This is not just strategic, the Treasury has also argued that it doesn't have the authority to selectively make payments anyway.

Although we have never tripped it, just setting the tripwire every few years has been hurting our economy and raising costs for the government. The U.S. Government Accountability Office reports that in the runup to the last debt ceiling standoff in 2013, two things happened. First, the impasse disrupted U.S. financial markets as investors eschewed Treasuries that matured around the dates the debt limit could be breached. Second, these standoffs, even though they were resolved, led to higher borrowing costs for the government going forward.

The current deal, which just resets the tripwire for 2021, does not solve the fundamental problem: If Congress is concerned about the national debt, it needs to address it proactively by setting tax and spending policy to reduce annual deficits. A standoff after the fact when the country veers toward an arbitrary and inevitable limit that was the result of previous decisions on taxing and spending is a dangerous way to run the country. True, we have been doing it this way for a century, but unless Congress changes the budget process to link spending and tax decisions with the debt limit, investors should expect periodic disruptions and the risk of a major, completely avoidable financial crisis.