Who is afraid of the Big Bad Debt?

The impending United States Government Debt Ceiling Default Crisis raises an interesting question: is this more like the Y2K crisis or like the bank run leading to the Great Depression. It all depends upon who you think Uncle Sam is.

Let me explain, first off: the debt ceiling is a legislative fiction; it is not real. It is imposed by the government on itself, and so the government can just as easily undo it. For example, the Congress can pass and the President can sign an increase in the authorized debt, or even a law that simply suspends enforcement. The Treasury can finagle revenues coming in and payments going out to extend when the debt ceiling is exceeded. Some have even suggested the Treasury could mint a so-called trillion dollar coin, in effect a non-negotiable trick to say, “here’s the money, so we don’t have any debt.” That last one is arguable, but serves to make the point how artificial this crisis is.

Second, the Democrats and Republicans have driven wildly toward the debt ceiling cliff many times, and always find a way to swerve or hit the breaks in the end. One time it may be different, but there is much history supporting more of the same.

No one knows exactly what the consequences of a debt limit default would be. The real inability to pay off debt–for a country or a person–is a serious thing. But the debt ceiling is not that. Most agree the stock markets would drop, as they fear uncertainty, and just the fact that the political parties didn’t avoid a technical default is a higher degree of uncertainty. But the markets are a difficult sign to read. Some investors believe the government will service their bonds first, so they will continue to get paid (as revenues come in). Others are short-selling, predicting a big market correction from which they would make millions.

But none of that is permanent. Would it send the economy into a recession, since all the other fundamentals don’t change? Would it change the willingness of Saudi Arabia, Japan, and China to buy US government debt? Remember, it’s a technical default: the US government and the Gross Domestic Product remain the same, and the US dollar is still the world’s reserve currency. So no one knows how it will play out. Am I worried? No, but I am prepared. Why? If a technical default occurs, I am sure things like federal pay and pensions will be among the first things that don’t get paid; social security, medicare, and military pay will all come first, although even those will be at risk. There simply isn’t enough revenue coming in monthly to pay the bonds and the entitlements and everything else.

Let’s use a personal metaphor. Imagine Elon Musk, he of an enormous fortune, is sailing on his yacht in the remote South Pacific when he hits a perfect storm, his boat sinks, and he washes ashore on a remote island as the sole survivor. Being incredibly lucky, this island has a small, non-cannibalistic population, and the first thing Elon sees is a small palapa with a “restaurant” sign! He wanders in, sits down, and waves to the waiter. The waiter, a vaguely Samoan-looking character who appears as if he could play nose tackle for the Cincinnati Bengals, takes one look at the soaking-wet, disheveled man and thinks “not another drunk tourist!?!?” but hands him a menu. Elon slams down several glasses of water, then some fresh fish, all the while amazed at his good luck. The waiter brings the check, and Elon realizes his wallet and his credit card holder are gone. He finds his iPhone in a special secured pocket, but it’s a sodden paperweight. He starts to explain about who he is, why he is there, but the waiter, certain it’s time to launch another drunk, is having none of it: he doesn’t know an “Elon Musk” from a “Musk Ox.” As he drags Mr. Musk by the collar towards the door (the palapa may have no walls, but it does have a door!), a woman, the restaurant owner, walks in and does a double take. “Elon Musk? Really?” she stammers. It seems Mr. Musk’s good luck has returned. The waiter re-deposits him at his table, and Elon recounts his story to the owner. He offers to invest in her restaurant, gives her an IOU for $50,000 dollars, and agrees to do a selfie for her to post on social media.

Fun story, what? But what does this have to do with the debt ceiling crisis? Elon Musk is Uncle Sam: fabulously wealthy, but out of available cash at the moment. The waiter is the market, which isn’t sure about anyone or anything, hates uncertainty, looks at the immediate situation and starts to react. The restaurant owner is the rest of the investing world. They see the situation in front of them, but they also recognize the larger implications, and they react differently. Which is why you shouldn’t worry (too much) about the debt ceiling crisis.

Imagine our shipwreck scenario again, only the survivor is Donald Trump. He of at least four bankruptcies, a tendency to overstate his wealth and litigate any debt. If you’re the restaurant owner, do you give him a pass? That’s the US if it ignores the debt (not debt ceiling) problem. Maybe they all decide enough is enough, and the global economy crashes. We don’t know whether we’re Elon Musk or Donald Trump in the eyes of the world’s investors. Which is a reason to worry.

The real problem is not the debt ceiling, but rather the debt itself. The US government owes tons of money. . . literally. It owes $31T as in Trillion dollars: 31,000,000,000,000. That’s over 34,ooo tons of dollar bills. Is that a lot? Well, just like for a person, it only matters if they can’t pay it.

The US Gross Domestic Product (GDP, a measure of the total resources available to the country) is over $25T, so we’re a little over-leveraged. Of course the all the debt never comes due at once, but the government can’t access all the GDP, either.

Add in to that the credit history of the United States: from the original debt of the 13 colonies, through the Union (not Confederate) Civil War debt and the enormous federal expansion during World War II, then the Cold War and creation of the New Deal social welfare state, the US Government has always, ALWAYS, paid off its debt on time and in full. And as any creditor will tell you, that counts for a lot.

Finally, in addition to its tangible assets, like the ability to raise revenue and print money, the US government has intangible but important assets, like the world’s greatest military. What’s it worth? When you need it, priceless!

So far the debt monster is undeniably large, but seems manageable. Now let’s look at how the US Government finances that debt. The US can run large annual deficits (the difference between revenues coming in and payments going out) because it issues bonds: federal IOUs that pay interest, which are bought by investors. These IOUs are highly sought after, because of America’s stability (we don’t devalue our currency, we don’t nationalize other people’s assets) and payment history. When you have cash and you want to it to grow while being protected, nothing works like US bonds. Which is why China, and Japan, and Saudi Arabia hold so much of this debt. It’s not necessarily a bad thing being “in hock” to foreign governments. We took their dollars and gave them paper, which is only worth something as long as the US is around. Yes, they could try selling it all at once to harm the US, but that would involve destroying all their investments at the same time. It’s mutually beneficial, so it works. Banks, investment firms, insurance companies, pension plans and private investors all buy US debt, too, for all the same reasons.

Another big holder of US debt is (wait for it) the US government. What? The two largest government holders of government debt are the Federal Reserve (aka the Fed) and the Social Security Trust Fund. The Fed started large-scale buying of debt during the 2008 financial crisis. It didn’t have to, but it bought up federal debt from banks and others to keep the markets liquid (flowing) and prevent a depression. In effect, it “created money” just like the Treasury does, except the Treasury prints it while the Fed just creates it digitally. The Fed can decide when to sell those bonds and is starting to do so gradually, so as not to upset the markets.

All that money they take out of your paycheck under the heading OASDI (Old Age, Survivors, and Disability Insurance)? That’s your input into Social Security. The Social Security Trust Fund takes the extra left-over after paying out benefits and buys US government bonds. So the Trust Fund is full of IOUs, not dollars. But that’s not a problem, because the US government always pays off its IOUs on time. Right now, the amount the Trust fund pays out is about the same as it takes in, but as the baby boomers continue to retire, and there are fewer workers out there paying OASDI, the Trust Fund will need to cash in its IOUs. Current estimates (and they change annually) say that the IOUs will be all used up by 2034. At that point, most of the Social Security payments will have to be appropriated, since the Trust Fund can’t send you (as a social security recipient) a government IOU, what you want is a dollar.

Which is not to say Social Security is the problem. There are other entitlements (which for God’s sake, don’t ever complain about this word, as it means it is a legally required payment, not optional, and it has nothing to do with being “entitled” in popular usage) like Medicare and Medicaid which have similar issues, not to mention our federal tax code which is larded with tax breaks for corporations, wealthy investors, and homeowners. It is never one thing, it is always every thing, together.

As you already know, the larger circle is expenditures, the smaller is revenues, meaning the US once again ran a deficit. The administration points out the deficit was reduced last year, and I guess in these extraordinary times, that’s something. But it’s like a drunk telling you he only drinks half-a-bottle-of-whisky-a-day now: relevant, but not addressing the fundamental problem. Look again at Social Security, Medicare, Income Security, and Net Interest; these are mandatory budget items, requiring no Congressional approval. Most of these programs increase every year. For example, we still have ten more years of ten-thousand baby-boomers retiring every day, and as they apply for Social Security, that expenditure will steadily increase. Only about a third of the federal budget is discretionary spending, and it includes things like defense and education spending. Eventually (like in a decade or two), the entire federal revenue stream will be eaten up by mandatory spending if nothing changes.

What does it matter if institutional investors (countries and firms and people) will keep buying US issued debt? It doesn’t. The US can keep going on running an annual deficit, selling bonds to finance the debt, and nothing changes. But that willingness to buy US debt is built on a fragile, psychological base: the US is a stable, growing, responsible payer of debt. As we get to the point where we can’t pass a budget without huge increases in taxes or drastic reductions in spending (including benefits), who will continue to believe that? And once that trust is gone, it’s very difficult to reacquire.

The thing is, a series of small changes could place the US federal budget on a firmer path for many decades. Simply removing the cap on Social Security taxes (they stop collecting the tax above $160,000 income), means-testing payments for the very wealthy, and delaying the retirement age to 70 help a great deal. Creating a sovereign wealth fund to invest in market securities and help pay for entitlements is another great idea, or allowing the Social Security Trust Fund greater leeway in investments is another. A national sales tax is another good idea. And before you clutch your pearls (I’m thinking of the White House here), if it’s so regressive how come nearly all the progressive social democracies use it? Plus, the government could exempt groceries, for example (under a certain limit; we don’t need to have tax-free foie gras, as much as I like it!). Perhaps a separate value-added tax on items costing over $100k and a small financial transactions tax on securities would be nice additions. I’m open to any suggestions on consolidating (not cutting) federal welfare programs, where any savings would come from eliminating bureaucracies, not reducing benefits.

As things stand now, Republicans are for cutting entitlements and taxes, while Democrats appear to want to raise both. Neither approach will resolve our growing debt problem. When the two sides do compromise, like during a recent debt ceiling crisis in the Obama administration, they mostly compromise on revenue-neutral provisions, which don’t add to the deficit, but don’t reduce it either. That also fails the test, because soon we still run out of discretionary spending.

If you would like to play around with fixing the deficit/debt yourself, check out this website where you can tweak the variables and see how you do. I got within $50B (chump change with respect to the federal budget) of stabilizing the debt at 90% of GDP. It’s actually not that hard, if you try. The larger point is we don’t need to produce a balanced budget (which is practically impossible at this point), we only need to show we’re willing to reduce spending and raise revenue.

In the meantime, our political leaders (both sides) seem content to posture and pretend there is no problem, other than the opposing party. One side or the other will claim to “win” the debt ceiling default crisis. If the President agrees to cuts, the GOP will crow; if the Speaker agrees to raise or suspend the ceiling without cuts, the Democrats will do so. But nobody wins here, because the day after this ends, the debt still looms. It won’t really be a problem until it is, and then it will be too late.

Ernest Hemingway, when asked “how did you go bankrupt?” said, “gradually, then suddenly.”