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Looming Crisis Over U.S. Debt Ceiling

It may be too much for most people to fully comprehend the size of the government’s $14.3 trillion debt, so let’s put this in terms each of us can understand – yesterday the United States maxed out all its credit cards [1].

By law, the government is restricted to a debt ceiling of $14.294 trillion. This limit came into play on Monday and means the government is effectively prevented from selling bonds and taking on any further debt. The Treasury Department released a somber statement noting that by raiding the nation’s pension funds it could manage to meet the nation’s debt obligations until mid-summer, but unless new funds are available by then, the Treasury would have no choice but to default on some of the country’s debt obligations.

Mandatory Spending vrs. Discretionary

The U.S. debt has become a ferocious beast with an insatiable appetite [2]. In 2010, mandatory spending grew nearly 15 percent over the previous year and totaled $2.17 trillion. At the top of the list was Social Security at a shade under $700 billion with Medicare / Medicaid following at $453 billion and $290 billion respectively. It is also noteworthy that interest on the national debt – also a mandatory expenditure – cost American taxpayers $164 billion for the year.

Discretionary spending for 2010 was also up significantly gaining almost 14 percent over the previous year to $1.38 trillion. Defense spending as you might imagine, was the number one expenditure on the discretionary side accounting for $663.7 billion. By comparison, the remaining discretionary totals are minuscule with the number two category – the Department of Energy – accounting for “only” $26.3 billion.

Here is the problem facing lawmakers. Mandatory spending is just that – mandatory. In other words, the government has few options to find savings in these areas. With respect to discretionary spending, other than the big-ticket defense spending, the remaining expenditures are – relatively speaking – insignificant. Locating a spare trillion or so in this category will require significant cutbacks across many different departments and would take months to complete; the government has at best, a few weeks.

So why not simply raise the lending limit? Well, this would be the obvious solution but the typical back-room shenanigans are in full-bloom in Washington right now and it is unclear when this approval may come. Both sides are using the debate to positions themselves as the better steward of the nation’s finances and should this partisan back-and-forth continue past the Treasury’s warning date, some form of default is unavoidable. Treasury officials are already quietly considering the worst case scenario and are identifying areas where a default would create the least damage.

If it comes to that extreme, it seems unlikely that the government would risk sacrificing its credit rating by defaulting on its interest payments. The resulting collapse in investor confidence would force yields much higher on subsequent bond offerings and this would have grave consequences on America’s ability to raise funds in the future. After all, the U.S. will be forced to rely on deficit financing for the foreseeable future so this option is a non-starter.

It is also hard to imagine that the government will take the route of slashing healthcare or dismantling other social programs. This would be a tough sell with the 2012 election campaign about to kick-off in earnest but the political posturing does serve to set up the debate between the two camps – the Democrats who favor minimal spending cuts with increased taxes, and the Republicans who demand dramatic spending cuts as the cost for garnering their support for raising the credit limit.

So far, it appears that both sides are more concerned with scoring political points at each other’s expense rather than tackling what could quickly become a crisis issue. Despite the looming election, both sides would be well-advised to ease up on the politics until the financing question is settled for the short term at least.

A good start would be to remove the specter of a default by approving an increase in the borrowing limits ASAP. Once markets are reassured that a default is not going to happen, then lawmakers can address the larger question of spending and taxes.

Oh, and here is something else to keep in mind – just because the limit has been increased on your credit card, it doesn’t mean to have to spend it.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

Scott Boyd

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