It’s Time to Scrap the Debt Limit
The US government debt limit will soon be in focus again, possibly leading to another round of needless economic and financial market uncertainty.
A quick resolution would support the notion that President Trump represents a transition to more effective and results-oriented leadership, and a shake-up of “business as usual” in Washington. But more probable is a repeat of previous debt limit confrontations and last-minute agreements, revealing sharp fiscal and other policy differences between Congress and the administration, and underscoring persistent weaknesses in US fiscal governance.
The Bipartisan Budget Act of 2015 suspended the federal government statutory debt limit until March 15, 2017, when it will be reinstated and set at the level of the debt. The Treasury Department will then rely on “extraordinary measures” to ensure government payment obligations are met in full, including interest payments. The extraordinary measures invoked will likely be similar to those deployed when previous debt limits were reached. Specifically, the Treasury can stop investing surpluses of government pension and other funds in newly issued securities, and can redeem some fund holdings prematurely, creating room to finance shortfalls between government revenues and expenditures.
Debt Limit Does Not Impose Discipline
The Treasury Department is able to cope temporarily with debt at the limit, but there are several shortcomings associated with the debt limit framework and how new limits have been set.
The most fundamental problem is that the limit imposes no additional fiscal discipline, and serves no meaningful purpose in the management of public finances. Fiscal debates centre on the annual budget, and particularly the various appropriation bills — or, in their increasingly common absences, continuing resolutions — that fund discretionary spending. Revenue and mandatory spending changes can also be part of the budget process, but are governed by different legislation that does not need to be reviewed or approved annually.
As the amount of debt outstanding is solely a consequence of previous revenue and spending decisions, and proximity of debt to the limit is not considered as part of the budget process, the debt limit is both redundant and potentially inconsistent with other legislation, particularly if it is in danger of being breached. The limit provides no guidance to — and has no influence over — fiscal policy decisions.
A debt limit that is periodically reached presents an avoidable burden for the Treasury, created largely by political posturing and brinkmanship possibly focused on issues unrelated to public finances. Treasury efforts to prevent debt exceeding the limit are a waste of operational resources.
The biggest risk associated with the debt limit is that Treasury may exhaust its extraordinary measures before the limit is increased, raising the possibility of payment interruptions, potentially including interest on securities. The debt limit crises of 2011 and 2013 showed that this is a material risk. On both occasions, last-minute agreements were reached, but there was considerable uncertainty due to political manoeuvrings that continued until time had nearly run out.
It was revealed last year by the House Committee on Financial Services that Treasury can prioritize debt service payments if extraordinary measures are exhausted, implying there would be no default on government securities. In such a scenario, however, there would be other financial obligations that were not met, taking debt limit standoffs into new and even more dangerous territory.
There is a view that Congress will always “do the right thing” in the end and take action in time to avoid payment interruptions. But Congress was also expected to agree to deficit reduction measures under the Budget Control Act of 2011, which averted a payments crisis by raising the debt limit in early August, and established a joint committee to formulate a 10-year deficit reduction strategy by late November. The threat of sequestration (automatic, near across-the-board spending cuts from 2013 to 2021) was considered a sufficiently strong incentive to ensure Congress would act, but it failed to do so, triggering annual cuts that are now built into the budget framework.
A Better Way: Lifting — Or Abolishing — the Limit
On a longer view, repeated episodes of last-minute debt limit resolution undermine the US’s reputation for responsible fiscal management. Recurring risks of a US government payment interruption may eventually result in the dollar ceding ground as the world’s pre-eminent reserve currency and the Treasury market losing its status as the primary benchmark for the global pricing of risk-free assets. These developments would carry real economic costs for both the public and private sectors that are difficult to estimate but could be high.
The extended federal fiscal outlook entails ever-increasing government debt, according to Congressional Budget Office baseline forecasts, suggesting the debt limit will need to ratchet higher for the foreseeable future. Given the fiscal outlook, Congress and the administration may want to consider an alternative, more predictable procedure for setting the debt limit, acknowledging its lack of value as a policy anchor and the various risks it raises when in play politically. One option would be to amend the law so that House approval of a budget resolution would carry with it approval of a rise in the debt limit, as was the case under the “Gephardt Rule” enacted in 1979 and later abolished.
A better option would be to scrap the debt limit altogether.
There is a real fiscal agenda to be addressed in the US focused on curtailing mandatory spending to avoid rising deficits and debt. Allowing policymakers’ attention to be diverted periodically by the debt limit because it offers an opportunity for political posturing and negotiation is at best counterproductive and at worst may prove very costly.