Understanding the Debt Ceiling Debate

Anyone who has watched cable TV in America over the last few weeks has probably seen ads attacking the Obama administration and calling for an end to an increase in the debt ceiling. The ads point out several truths about the economy since Obama took over in 2009. The unemployment level has gone up and the federal debt level has increased by a large margin. The problem with these ads is they use true facts to lead to a false conclusion and an even worse policy prescription for America.

 

The Debt Ceiling

Regardless of who should be blamed for America’s economic woes, not raising the debt ceiling would probably be the stupidest thing that the government could do. The fact is that the United States government has not had a balanced budget since 2001. It has been running a deficit for the last decade, and with a deficit, the total amount of debt will inevitably increase.

The United States Congress has to approve of any increase in the total amount of debt that the American government takes on. This is the debt ceiling, which must be adjusted to reflect deficits. The ceiling currently sits at $14.3 trillion, but must be increased to reflect new deficits that the government needs to take on to function.

Obviously the size of America’s deficits is a problem that needs to be addressed. However, the fact is that there is currently a deficit and the debt ceiling needs to be increased to pay for the American government to run. If the debt ceiling is not increased, the government will not have the money to pay its obligations to employees, debtors and federal programs.

Imagine a guy who owns a house worth $500,000.00 and a home business. He has borrowed $200,000.00 and is making payments on the $200,000.00 debt. The bank is offering to give him another $50,000.00 in debt to finance his home business and make the payments on the debt. He refuses and decides that $200,000.00 in debt is too high, and that rather than taking the loan, he will leave the debt as is. However, his income is not enough to make the monthly payments on the loan and pay his business’s employees. So, he doesn’t make his interest payments or pay his employees. What will happen? The bank will foreclose and the employees will be out of work. The person will lose his home and business. Game over.

Rather than a home, the American Government has its economy as collateral for its debts. Investors have lots of confidence in the strength of the economy, and are therefore willing to lend money to the government. By not increasing the debt ceiling, the government is refusing to take on the debt that it needs to survive.

If the American government doesn’t increase the debt ceiling, we will see a financial crisis like the world has never seen. It will be even worse than the one that happened in 2008.  Investors and foreign countries will lose confidence in the US government. There will be a massive sell off of government bonds and treasury bills, which are normally considered the most secure instruments. Total Armageddon could ensue, especially with the world economy already in a fragile state. The Federal Reserve would likely use its reserves to delay the problem a little longer, but eventually the ceiling will have to budge for the economy to survive.

 

The Republican Strategy

Fortunately, the Republican Party is mostly filled with rational actors who are aware of the necessity of raising the debt ceiling. The Republicans, however, have used this opportunity for their own political purposes. They realize the power that they hold with respect to approving of the increase in the debt ceiling through their control the House of Representatives.

The Republicans are using the opportunity to starve the government, fire government workers, take health care away from senior citizens, and take away regulatory agencies that protect the environment and the general public. Federal government programs that help the poor and underprivileged are being cut.

The Paul Ryan plan for Medicare reform will certainly be a step in the wrong direction. This plan intends to pass off the costs of the deficit to the senior citizens of the future (i.e. people currently under 55). The Plan will take away insurance coverage for seniors and instead provide seniors with a voucher to purchase insurance from private companies. Of course, eventually the laws of economics will send prices for health coverage higher than the vouchers, and seniors will have to dig into their savings to purchase health insurance. Seniors without savings will end up with inferior healthcare plans, which will lead to deaths from treatable illnesses.

Of course, the Republicans would say that this is an opportunity to get deficits under control for the long term future of America. This comes after several studies have shown that at its current rate, the government’s deficits will keep on expanding, and eventually the country will no longer be able to afford to pay for government programs or make interest payments on government debt. This is scheduled to occur in the 2020s without any changes under the status quo. This obviously is a serious concern, which can’t be passed off to future generations.

The problem with the Republican solution to this issue is that they refuse to budge on the revenue side of the equation. With an increase in revenues, the government could afford to pay for its obligations like Medicare, Medicaid and Social Security, although these programs do need some minor reforms to save on costs.

Think about the U.S. government as a company. The company is operating at a loss. Revenues coming in are less than expenses. The company has to take on debt to pay its expenses. To balance its budget, there are two options: cut expenses or increase revenues. Of course, the company could do both and return to profitability.

 

Taxes

So, how does the U.S. Government increase its revenue? Taxes! The government should be paying its expenses with tax dollars from its Citizens, not from money that is borrowed, right? Not necessarily. Debts can be good for governments, allowing them to expand at a quicker rate and increase ownership of the country by its citizens, who buy government debt. It can help relationships with other countries, allowing countries to invest in each other and become interconnected. Of course, debts do need to be manageable to prevent a default on interest payments.

So if the Republicans are really so concerned about the deficit, why don’t they just increase taxes? The answer is that there is a pervasive dogma that has infiltrated the Republican Party. This dogma states that any increase in taxes will actually lead to a decrease in total revenue. The logic goes that lower taxes allow the economy to expand, which will actually increase total government revenues.

A company or person that pays 40% in taxes with profits or income of $100,000.00 will pay $40,000 to the federal government. A company or person that pays 25% in taxes with profits or income of $200,000.00 will pay $50,000 to the federal government. Therefore, if cutting the tax rate from 40% to 25% will allow the company to double its total profits, then the tax cut will actually lead to more government revenue!

Of course, the major caveat with this theory is that lower taxes must lead to increased profits or income to compensate for the decrease in government revenue per dollar earned. The Republican theory has basically become that any decrease in taxes will lead to an increase in total profitability that will more than compensate for the decrease.  If the theory were really valid, then taxes should just be decreased to 1%, because with taxes this low, the economy would expand exponentially.

What is to say that the company’s profits will double if its taxes are cut in half? The truth is that with any economic principle, the results are inevitably parabolic. At a certain rate, you can cut taxes, but the effect will not increase the company’s profit to account for the decrease in revenue. There is going to be a tax rate at which total revenues are maximized.

The Republicans would make the argument that this rate is lower than the current rate, and that taxes must continually be slashed until the perfect rate is found. However, this would assume that the “incredibly high” taxes that companies and individuals are currently paying are keeping them from making money. The thing is, companies are making tons of money, even after taxes. Many individuals are also making lots of money, and even after taxes, are still walking home with a lot. Yet, the economy is still stagnant.

The federal government does need to make spending cuts as part of its deficit reduction plans, but the Republicans want to turn America in to a third world country to do this. Any nation that punishes its poor, elderly and unfortunate is not going to be successful in the long run. These are long term problems, and the government needs to come up with long term solutions, which must include increasing revenue by raising taxes.

 

The U.S. Economy

The U.S. economy is not stagnating because taxes are too high. Companies are making huge after tax profits, and individuals who do have jobs have lots of disposable income after taxes. The problem is that after a decade of insane consumption and borrowing, followed by an economic meltdown, businesses and individuals are still in a state of shock. Companies are reluctant to hire new employees, and people are more likely to save than to spend. Companies have become more efficient, and can make the same revenue with fewer employees. This problem will only be solved by an increase in confidence, technological innovation, and government investment.

The compromise made at the end of 2010 shows that keeping taxes low did not have a serious stimulating effect on the economy, at least not enough to compensate for the loss in revenue associated with the cuts. The compromise prevented taxes on the rich from going up to pre-Bush levels of 39.6% (from 35%). It also changed the estate tax so that heirs to multi-million dollar fortunes would no longer have to pay taxes on the first $5,000,000 of their inheritance (or $10,000,000 for estates of couples), and would pay a tax rate of 35% on any inheritance above that amount. There may have been a small effect from this cut, but it has not had the stimulating powers that the Republicans promised.

The US economy is getting better, but it is happening very slowly. The biggest lie being spread by Republicans is that the stimulus package failed. The U.S. has had 7 consecutive quarters of positive GDP growth. Employment has been trending upwards since March, 2010, and there hasn’t been a month with net job losses since September, 2010.

The Republican Party is trying to take advantage of the short term memory that people have and blame the US economic problems on the person who has been fixing them, not on the people who caused them. The bad economy that we are experiencing is still the result of the horrible catastrophe that was caused by the Republican Party’s deregulation of the financial sector. This is still Bush’s recession, even though Obama has been trying to make it better.

Many parts of the stimulus package kept the economy from getting worse than it did. For example, the extension of unemployment benefits in the package kept money in the pockets of the millions of unemployed. They were able to use that money to buy food, rent apartments, and generally remain consumers in the economy. Each expenditure within the stimulus package can be directly related to an infiltration of dollars into the U.S. economy.

When Obama took over, the economy was in a horrible downward spiral. Hundreds of thousands of jobs were being lost every week. After the bailouts and the stimulus package, the economy stabilized and things began going in the right direction. The stimulus worked. It will take a long time to dig out of this whole, but at least we are no longer in the bottom and are on our way out. Obama did all that could possibly be done. He’s a politician, not a God.

Of course, if the debt ceiling isn’t raised, we could go right back in to the hole. Hopefully an agreement will be reached that solves some long-term problems, doesn’t punish the poor too much, and increases revenues. Until then, we can only watch the farce go on and hope for the best.