Bailout

Why do we have a debt ceiling?

By Felix Salmon

Can someone please explain to me why we have a debt ceiling at all? Its existence seems to violate every tenet of risk management and good governance.

James Hamilton put it well back in 2006:

One of the peculiar embarrassments of the American political process is the fact that Congress votes separately on the deficit and debt, as if they were two different decisions…

If the government is (a) required by the deficit legislation to spend, and (b) precluded by the debt legislation from borrowing, the Treasury would be forced into default. The greater the likelihood markets attach to such an event, the higher will be the interest rate the government has to pay on Treasury debt. A politician who votes for the spending and tax measures that produced the deficit but against a debt ceiling consistent with these is deliberately wasting taxpayer dollars for no purpose other than to grandstand before voters as a “fiscal conservative”. Anyone playing such a game has complete contempt for the intelligence of their constituents.

Looked at another way, this has very little to do with hypocrisy or the voting records of individual legislators. Instead, it’s a built-in systemic stupidity: the existence of the debt ceiling can cause lots of harm, while it does no good whatsoever. As a result, at the margin it will always needlessly raise US borrowing costs, at least by some small amount.

But it’s worse than that?not only is the debt ceiling an utter idiocy, it’s also extremely popular, in a way which only serves to ratify any contempt which US politicians have for the intelligence of their constituents:

71 percent of those surveyed oppose increasing the borrowing authority…

Expensive benefit programs that account for nearly half of all federal spending enjoy widespread support, the poll found. Only 20 percent supported paring Social Security retirement benefits while a mere 23 supported cutbacks to the Medicare health-insurance program.

Some 73 percent support scaling back foreign aid and 65 percent support cutting back on tax collection.

There’s no particular reason why the US public needs to have a reasonably sophisticated understanding of credit spreads, default risk, and the federal budget. I daresay that lots of people genuinely believe that if you cut back foreign aid and tax collection, that would obviate the need to raise the debt ceiling. But the consequence of this is that it gives a real incentive to politicians to vote against raising the debt ceiling, and to attack their opponents, in elections, for repeatedly voting for such a raise.

In other countries, hard limits on debt issuance or total debt or debt servicing costs constitute a serious fiscal commitment and credit risk. In the US, they’re a political distraction at best, and a massive potential tail risk at worst. I’d love to know how this bonkers system came to be, and whether there’s any way of getting rid of it.

Update: Wikipedia tells me that the debt ceiling was introduced to replace a system where Congress approved every debt issuance individually. Which makes sense as a halfway-house on the road to getting rid of this silly constraint completely.

Full post as published by Macroprudential on January 12, 2011 (boomark / email).