Tuesday, July 12, 2011

The Debt Limit

I have been puzzled by claims that a binding debt limit  somehow implies default on the existing debt.

Some pundits imply that it is somehow natural to assume that interest on the national debt is funded by additional borrowing.   If no additional borrowing is allowed, then interest cannot be paid.   If interest on the national debt cannot be paid, then there is a default on what is owed.

Other pundits correctly note that interest could be paid out of current revenues, but they sometimes add that principal could be paid out of current revenues as well.   While it is correct that principal could be paid out of current tax revenues, which is how the national debt might one day be decreased, this is little connected to the debt limit--a prohibition on additional borrowing.

The basic outline of the problem is that if no additional borrowing is allowed, then as bonds come due, the actual national debt falls by the amount of principal that must be paid.   That means that funds can be borrowed to repay principal while remaining at the limit.    On the other hand, the interest on the national debt is a current expense and must be paid out of current revenue.

Since current revenue is less than current expenses, which includes interest on the national debt, there is a budget deficit.   To fund that budget deficit, the debt limit must be increased.   If it is not increased, then the budget must be balanced.   Either revenues must be increased, say by tax increases, or else current expenses must be cut.

To repeat, a binding debt limit requires that the budget be balanced.   Current revenues must match current expenses, and that includes the interest expense of any existing debt.

Default on the national debt, in particular, the interest payments owed, would occur only if other current expenses are prioritized over the interest payments.     While some might think this is desirable, it is hardly necessary.

Some pundits have argued that because appropriations from Congress are laws, the money must be spent by the President, and so, the President must borrow the money, regardless of any debt limit.     Perhaps, but municipal governments, for example, also have budgets that are passed by ordinance--that is, by law.   And there are other laws, generally set by the state, that restrict borrowing and taxes.   Further, some expenditures involve contractual obligations that "must" be paid.   Other expenditures may be authorized by ordinance, but there is nothing very specific about the timing.    If tax revenues come in less than expected, and there is no authorization to borrow, then the contractual obligations must be paid (interest and principle on debt, for example,) and then other expenditures must be postponed until more funds are received.

Of course, there is no "higher" authority, other than the Constitution, that limits what Congress may do.   But suppose there was no national debt and Congress authorized no borrowing.   Yes, imagine that the U.S. government operates with no borrowing at all.

Further suppose that Congress also sets up a schedule of customs duties, and generates revenue.    Congress appropriates expenditures, say, building forts to protect the coast from invaders.    The customs duties are expected to bring in $200 million, and forts cost $50 million.   Congress appropriates funds to purchase four forts.

Well, as funds arrive at the Treasury, the President starts having the forts constructed.   Construction only becomes possible as funds arrive.   Unfortunately, only $180 million arrive over the year.   At the end of the year, one of the forts is left incomplete.    Has the President violated the law?

I think it is evident that the President has not violated the law.

Now, suppose Congress had prioritized the forts, and at the end of the year, a lower priority fort is complete and a higher priority fort is incomplete.   Here, the President has violated the law, and impeachment may be appropriate.   Of course, a reasonable defense would be that the President planned to complete all of them, but lack of funds, or some other hold up in construction, resulted in the higher priority fort not being completed.

Only if one assumes that Congress has authorized borrowing does it make sense to say that a lack of tax revenues can never be a reason to restrict expenditures.    So, for example, if Congress has authorized borrowing subject to a limit, and the national debt is below that limit, and the President refuses to spend money because he doesn't favor deficit spending or believes that the increase in the national debt (still below the limit) is already too high, then this would be breaking the law.   But that doesn't mean that limiting expenditures to the funds received once the limit is reached is "illegal."

Personally, I don't think that default on the national debt is the same thing as repudiation.   Default happens all the time, and those that default promise to resume payments as soon as possible.   And I certainly don't think that default on the current national debt involves questioning the repayment of the particular funds borrowed by the Lincoln administration to fund its effort to conquer the Southern states or the pensions promised to the soldiers who invaded those states.    I am pretty sure there are no remaining Civil War pensioners and little of today's national debt was issued for that purpose.


  1. What about printing the money?
    The Treasury, without new taxes and without new borrowing, can just print the money to pay its obligations.

    This may well cause inflation, later, but is legal and available today. In fact, there could be a 100% tax holiday and all the gov't could be run by printing money -- I think Zimbabwe is trying that last year.
    I don't advise it; I'd prefer spending cuts.
    But I'd rather more money printing than taxes.
    Tom Grey

  2. Principal on the national debt can not be paid with taxes. That is why the national debt will never get paid and that is why principal payments on maturing debt is not considered a Govt expenditure. Interest and deficit spending have to be "borrowed" in to existence because they don't actually exist.

  3. Tom Grey:

    Under the current setup, financing government expenditure by money creation still involves the issue of additional debt by the Treasury. The Treasury sells it to the general public, and the Fed buys it from the public. While the general public serves as a middleman here, the Treasury still has issued the debt, and debt held by the Fed counts under the debt limit. While that can be changed, so can the debt limit.

    The Treasury can directly issue currency, but Treasury currency takes the form of debt. It is just a Treasury note that doesn't bear interest. I don't know how the Courts would rule, and clearly, Congress could exempt Treasury currency from the debt limit by legislation, but they can just raise the debt limit.

    I favor explicit default over inflationary default. I think the quantity of money, whether issued by private banks, the Fed, or the Treasury, should adjust to meet the demand to hold it given a level of money expenditures on output (GDP) that remains on a slow, steady growth path. Having the Fed (or Treasury) create money based upon the politicians desire to fund spending is wrong.

  4. Anonymous 2:

    The government can use taxes to pay down principal. Why not?

    It is true that deficit financing must be borrowed. By definition, if a budget deficit is funded by raising taxes, then it is no longer a budget deficit. Interest, on the other hand, can either be borrowed or funded out of current revenues--out of taxes.

    The basic account for these things is that current revenues include things like taxes or user fees. It does not include receipts from borrowing.

    Current expenditures includes purchasing goods, paying salaries, and paying interest. It doesn't include paying down the principal on debt.

    A deficit exists when revenues are greater than expenditures.

    It can be funded by borrowing or asset sales.

    A budget deficit funded by borrowing increases the national debt.

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