Thursday, June 23, 2011

Raising the Roof... on the National Debt

For the past month, House Republicans and the White House have been in a bitter standoff over the national debt ceiling, the legal limit to borrowing that the U.S. government imposes on itself. The law establishing the ceiling has been in effect since 1917, but the ceiling has been raised many times over the past century. The current limit is set at $14.3 trillion. Government spending would have exceeded this limit on May 16th, but the U.S. Treasury has enacted emergency measures that will keep the government and its lenders funded until early August. Failing to increase the debt ceiling could lead to the U.S. being unable to fund military salaries, pay for programs like Medicare, or make interest payments to creditors. But increasing the debt ceiling won’t be easy either.

In the worst-case-scenario, an agreement to raise the debt ceiling would not be reached, and the U.S. government would risk defaulting on interest payments to lenders. The United States government has consistently served as a safe haven for lenders looking to store funds; historically it has never missed a payment. As a result of this reliability, the U.S. economy has been able to enjoy relatively low interest rates. If the U.S. were to consider defaulting on its loans, investing in the U.S. government would become riskier. To attract borrowers and accommodate for the increased risk of not being paid back, real interest rates would have to rise.

John Maynard Keynes wrote in The General Theory of Employment, Interest and Money that aggregate demand (composed of consumption, investment, and government expenditures) is the main determinant of an economy’s level of output. Investment spending, such as the purchase of a new home, is typically financed through borrowing. As real interest rates rise, borrowing becomes more expensive. Because investment is a component of aggregate demand, an abrupt decline in investment would theoretically shift the aggregate demand curve inward as in the graph below. With the US economy struggling to overcome the recession caused by the 2008-2009 financial crisis, a reduction in output and the corresponding fall in employment would certainly be viewed as an unfavorable outcome.

As part of the ongoing debt ceiling discussion, President Obama recently unveiled a plan to reduce deficits over the next twelve years that includes nearly $2 trillion in spending cuts and an increase in the debt ceiling. The government spends nearly $700 billion annually on national defense alone, and it also employs millions of people. As mentioned, government expenditure is a major component of aggregate demand. Economists would expect a reduction in government expenditures to shift aggregate demand inward in a similar manner as decreases to investment.

It is important to also consider the concept of “crowding out.” Whenever there is an increase in government spending, the resulting increase in incomes leads to increased spending and thus a higher demand for money. This increased demand for money causes increased interest rates. The opposite is also true. As government spending is reduced, so too are incomes, money demand, and interest rates. This reduction in interest rates makes borrowing cheaper, and thus stimulates greater private investment. Increased investment would therefore lessen the impact of a shock to aggregate demand from government spending cuts. Those in favor of spending cuts point to the increase in investment to suggest that the cuts won’t significantly decrease aggregate demand. Those opposed to the cuts note that interest rates are already very low so doubt that the cuts would spur much private investment.

It is relatively unlikely that US elected officials would be stubborn enough to permit a seemingly preventable crisis. Remember, the debt ceiling is a constraint that the government arbitrarily places on itself. No matter how the government chooses to proceed, the short-run economy is likely to see some negative consequences. Economists like to talk about optimal decision making, and recognize that sometimes even a “bad” option can be optimal if no other choice will lead to a better outcome. When it comes to the debt ceiling, let’s hope that our elected officials think like economists.

Discussion Questions:

1.) A number of nations around the world hold the U.S. dollar as their reserve currency. Others have periodically pegged their exchange rate to the U.S. dollar (China, for example). What would the implications of a U.S. credit default mean for foreign economies?

2.) Suppose that the debt ceiling remains unchanged. How might the US government prevent defaulting on its loans? How does this compare to the current plan suggested by President Obama?

3.) If you were President of the United States, how would you deal with the current level of debt? Would you increase taxes? If you were to cut programs, which ones would you cut? How might your view change if you were up for reelection?


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