Update: Added some great quotes from The New Yorker at the end of the post.

With all the doom and gloom about raising the debt limit of the US government (currently at $14.2 trillion dollars), it’s hard to remember that this is the original issue which started all this hysteria about government spending and whether or not to raise taxes.  I strongly believe that the debt limit itself is useless and does little to control spending.  There are far more useful market incentives to controlling the debt, and it is frustrating to watch this become such a political football when real people are the ones who suffer if the US defaults.

The debt limit of the US government has been raised over 80 times since its creation in the 1910s, under both Republican and Democratic congresses and presidents.  Under President Reagan, it was raised 16 times, while under President Clinton the debt limit was raised only 4 times.  So it doesn’t correspond with party affiliation as the pundits would have you believe.  The last time it was raised was February 12, 2010, by another $1.9 trillion dollars.  This was the only time the limit has been raised under the Obama Administration.

What is ridiculous is how some try to tie the debt ceiling to government spending.  The government drastically increased spending under Reagan, and Congress was happy to give him more debt room to do so.  A Republican Congress with Republican President Bush, also a big spender, raised the debt ceiling 7 times.   After 70 years of raising the debt ceiling any time it needed raising, it’s shocking that it would suddenly become a useful tool to control spending, when it never has been used as such before.  Furthermore, the idea that removing a source of income (borrowing) will inherently reduce spending has been proven patently false, even by conservative think tanks like the Cato Institute.

The sad matter of it all is that there is a very simple indicator for determining how much US debt is sustainable: US Treasury yields.  US Treasuries represent the interest rate the US government has to pay on its debt.  Like any investment, interest rates are low when the investment is considered low risk.  An investment with a high chance of vanishing tomorrow has to pay out a high interest rate (or high dividend) in order to keep investors interested.   In this sense, it’s as simple as looking at the rise and fall of Treasury interest rates to see if investors are growing skeptical or still believe the US government is stable and won’t default.

So, if things are so dire and the debt is overwhelming, those interest rates should be sky high.  Actually, interest rates are down by 50% versus a year earlier.  The real interest rate on a 10 year Treasury is 0.61%, compared to 1.21% a year ago.  Five years ago, the interest rate was 2.56%, and ten years ago it was 5.13%.  So judging by investor demand, the US government debt was 8x riskier 10 years ago.  Hmm…

It’s not as simple as that of course; the US still has a huge debt approaching 100% of GDP.  Treasury rates might skyrocket overnight if some new, nasty economic data gets revealed, or the deadlock in Congress continues.  But clearly someone out there still thinks the US government is trustworthy, and has enough willpower (if not cash) to service its debts.

Anyway, it seems clear that a debt ceiling doesn’t achieve the goal of managing spending, and should be scrapped.  Heated debate about taxation and spending should definitely be a duty of Congress, but holding the US hostage over the threat of default is stupid.  From my perspective, it looks to be a very poor move by Republicans to force spending cuts down Democrats’ throats.  The mature way to go about this would have been to raise the debt limit for another year back in May, then hammered out a deal this summer that involves reducing spending while also finding some way to generate more income, either by privatization of government resources, raising taxes, or closing tax loopholes.  The Republican demand of not raising taxes by a single penny is also extremely destructive to the talks.  Democrats love big government and have throw trillions of dollars in cuts on the table.  But the Republicans have yet to show any desire to budge.  It’s really quite disgusting it’s gotten this low.

So, Professor Andao says eliminate the debt ceiling, raise taxes, cut spending, and let interest rates determine when it’s time to slow down the spending further.  Simple, yet completely undoable in the current political environment.  Maybe next year.

Update:  Some great stuff by James Surowiecki.  Read full article here

The truth is that the United States doesn’t need, and shouldn’t have, a debt ceiling. Every other democratic country, with the exception of Denmark, does fine without one. There’s no debt limit in the Constitution. And, if Congress really wants to hold down government debt, it already has a way to do so that doesn’t risk economic chaos—namely, the annual budgeting process. The only reason we need to lift the debt ceiling, after all, is to pay for spending that Congress has already authorized. If the debt ceiling isn’t raised, we’ll face an absurd scenario in which Congress will have ordered the President to execute two laws that are flatly at odds with each other. If he obeys the debt ceiling, he cannot spend the money that Congress has told him to spend, which is why most government functions will be shut down. Yet if he spends the money as Congress has authorized him to he’ll end up violating the debt ceiling.

As precommitment devices go, however, the debt limit is both too weak and too strong. It’s too weak because Congress can simply vote to lift it, as it has done more than seventy times in the past fifty years. But it’s too strong because its negative consequences (default, higher interest rates, financial turmoil) are disastrously out of proportion to the behavior it’s trying to regulate. For the U.S. to default now, when investors are happily lending it money at exceedingly reasonable rates, would be akin to shooting yourself in the head for failing to follow your diet.

Read more:

Treasury Yields over time

“Starve The Beast” policy that doesn’t really work…

State Dept report on the Debt Ceiling

Cato Report on “Starve the Beast”

“The Economist” criticizes Republican actions