Who Needs the Debt Ceiling?
US lawmakers reached a budget deal this week that will avert the sequester cuts and shutdowns. These fiscal “roadblocks” supposedly damaged investor confidence in 2013, although clearly no one told equity investors who’ve chased the S&P 500 up 26 percent this year. But even so the budget deal is seen by as only half the battle won, because it doesn’t deal with the pesky debt ceiling. Unsurprisingly, the old calls for a scrapping of the debt ceiling are being heard afresh.
Last week, The Week ran an opinion piece by John Aziz which argues that America (and all other nations for that matter) should keep borrowing until investors no longer want to lend to it. To this end, it is argued, the US should scrap its debt ceiling because the only debt ceiling it needs is the one imposed by the market. When the market doesn’t want to lend to you anymore, bond yields will rise to such an extent that you can no longer afford to borrow any more money. You will reach your natural, market-determined debt ceiling. According to this line of reasoning, American bond yields are incredibly low, meaning there is no shortage of people willing to lend to Uncle Sam. So Washington should take advantage of these fantastically easy loans and leverage up.
Here’s part of the key paragraph from Aziz:
Right now interest rates are very low by historical standards, even after adjusting for inflation. This means that the government is not producing sufficient debt to satisfy the market demand. The main reason for that is the debt ceiling.
What this fails to appreciate is that interest rates are a heavily controlled price in all of today’s major economies. This is particularly true in the case of America, where the Federal Reserve controls short-term interest rates using open market operations (i.e., loaning newly printed money to banks) and manipulates long-term interest rates using quantitative easing. By injecting vast amounts of liquidity into the economy, the Fed makes it appear as though there is more savings than there really is. But US bond yields are currently no more a reflection of the market’s demand for US debt than a price ceiling on gasoline is a reflection of its booming supply. Contra the view expressed in The Week, low rates brought about by contrived zero-bound policy rates and trillions of dollars in QE can mislead the federal government into borrowing more while at the same time pushing savers and investors out of US bond markets and into riskier assets like corporate bonds, equities, exotic derivatives, emerging markets, and so on.
Greece once thought that the market was giving it the green light to “produce” more debt. Low borrowing rates for Greece were not a sign of fiscal health, however, but really just layer upon layer of false and contrived signals arising from easy ECB money, allowing Greece to hide behind Germany’s credit status. As it turned out, a legislative debt ceiling in Greece (one that was actually adhered to) would have been a far better idea than pretending this manipulated market was a fair reflection of reality. Investors were happy to absorb Greece’s debt until suddenly they weren’t.
This is the nature of sovereign debt accumulation driven by easy money and credit bubbles. It’s all going swimmingly until it’s not. And there is little reason to think this time the US is different. Except that America might be worse. The very fact of the Fed buying Treasuries with newly printed money proves Washington is producing too much debt. China even stated recently that it saw no more utility accumulating any more dollar debt assets. If the whole point of QE is to monetize impaired assets, then the Fed likely sees Treasury bonds as facing considerable impairment risk. Theory and history are clear about the reasons for and consequences of large-scale and persistent debt monetization.
Finally, it is wrong to assert that the debt ceiling is the main reason for America’s fiscal deficit reduction. The ceiling has never provided a meaningful barrier to America’s borrowing ambitions, hence the dozens of upward adjustments to the ceiling whenever it threatens to crimp the whims of Washington’s profligate classes. America’s rate of new borrowing is falling because all the money it has printed washed into the economic system and found its way back into tax revenues. Corporate profits are soaring to all-time highs on dirt cheap trade financing. Corporate high-grade debt issuance has set a new record in 2013. Companies are rolling their short-term debts, now super-cheap thanks to Bernanke’s money machine, and issuing long, into a bubbly IPO and corporate bond market. The last time corporate profits surged like they’re doing now was during the credit and housing bubble that preceded the unraveling and inevitable bust in 2008/09.
These are money and credit cycle effects. The debt ceiling has had precious little to do with it. Moreover, US debt is neither crimped nor the US Treasury Department austere. Instead, the national debt is soaring, $60,000 higher for every US family since Obama took office and rising. Add to this the fact that the US Treasury’s bond issuance schedule is actually set to rise in 2014 due to huge amounts of maturing debt needing to be rolled over next year, and the fiscal significance of the debt ceiling fades even further.
The singular brilliance of the debt ceiling however, is that it keeps reminding everyone that there is a growing national debt that never seems to shrink. That is a tremendous service to American citizens who live in the dark regarding the borrowing machinations of their political overlords. Yes, politicians keep raising the debt ceiling, but nowadays they have to bend themselves into ever twisty pretzels trying to explain why to their justifiably skeptical and cynical constituents. Most people don’t understand bond yields, quantitative easing, and Keynesian pump-a-thons too well, but they sure understand a debt ceiling.
Those who adhere to the don’t-stop-til-you-get-enough theory of sovereign borrowing, and by extension argue for a scrapping of the debt ceiling, couldn’t be more misguided. In free markets with no Fed money market distortion, interest rates can be a useful guide of the amount of real savings being made available to borrowers. When borrowers want to borrow more, real interest rates will rise, and at some point this crimps the marginal demand for borrowing, acting as a natural “debt ceiling.” But when markets are heavily distorted by central bank money printing and contrived zero-bound rates, interest rates utterly cease to serve this purpose for prolonged periods of time. What takes over is the false signals of the unsustainable business cycle which fools people into thinking there is more savings than there really is. Greece provides a recent real-world case study of this very phenomenon in action. In these cases we are likely to see low rates sustained during the increase in government borrowing, only for them to quickly reset higher and plunge a country into a debt trap which may force default or extreme money printing.
Debt monetization has a proven track record of ending badly. It is after all the implicit admission that no one but your monopoly money printer is willing to lend to you at the margin. The realization that this is unsustainable can take a while to sink in, but when it does, all it takes is an inevitable fat-tail event or crescendo of panic to topple the house of cards. If the market realizes it’s been duped into having too much before the government decides it’s had enough, a debt crisis won’t be far away.