By Gary Brode, Deep Knowledge Investing
For those of you who don’t follow the daily hyperventilating financial press, the big news during the last few weeks has been the potential debt default by the US government that will roil financial markets, make international trade uncertain, and cause a worldwide recession or worse. DKI has been tracking the issue for months, and we haven’t written about it because the entire subject is political theater. However, Treasury Secretary, Janet Yellen has declared the “x-date” could be as soon as June 1st. That’s the date the government runs out of money and “would” default, causing financial tragedy.
Over the weekend, House Majority Leader, Kevin McCarthy, met with the White House. Both sides declared they didn’t have enough common ground to arrive at a deal. Almost everything you’ve read in the press about the issue is complete nonsense (that means either lack of knowledge or lies) so let’s go through the details.
We’re going to give basic descriptions to make the issue more approachable. Congress approves spending and levels of taxation. When spending exceeds taxes, the government runs a deficit, requiring that the US borrow money. The Treasury Department along with the Federal Reserve issues debt to pay the difference. (Again – simplified version.) Add enough debt and currency creation, you end up with both inflation and rising interest payments that take up an increasing part of the government budget. Regular DKI readers are familiar with the conclusion here.
At some point, the government will need to cut spending. It will also need to create new dollars to pay the interest on prior debt. When that happens, there’s a debt death spiral, and the system proceeds to failure (default) or hyperinflation (stealth default). Once you’re printing currency to pay the interest expense, the system has almost certainly reached the point of no return.
Our current system has $31 trillion of on-balance sheet debt. There are also the off-balance sheet liabilities of future social security payments, Medicare, Medicaid, pension obligations, and other promises of benefits. These promises represent future payments which are not included in the official debt calculation. All of this adds up to about $250 trillion (a quarter of a quadrillion dollars) and is more than can be paid. We can get wound up over the current debt ceiling debate, but no matter what happens, a default of one sort or another is inevitable. There’s no level of taxation that will produce $250T.
The current fight is over the debt ceiling. Congress votes on a limit to how much debt the government is allowed to have outstanding. Every few years, excessive debt-funded spending forces Congress to vote to raise the debt ceiling. This has happened more than 100 times since the rule was put in place. Sometimes, the process proceeds smoothly. Other times, we have partial government shutdowns and threats to destroy the financial system and credibility of the US by defaulting.
Some will complain that the process is flawed. After all, how can we not fund the spending that was already approved? The system was designed specifically to create this problem. The debt ceiling exists to add friction to the process of piling up unlimited debt. Remember that any excess debt-funded spending we have now will need to be repaid by future generations. There is no “free lunch” here; but rather, an ability to live on credit until our debt becomes too large to manage. The current discussion/fight on spending levels and future debt levels is exactly why the debt ceiling exists.