The Corner

Interest Rates and Failure to Raise the Debt Ceiling

Talking to Bloomberg News, White House chief of staff William Daley said that a

failure by lawmakers to raise the legal limit on US borrowing could be ‘very dangerous’ and have ‘enormous potential negative impacts on the markets.

This argument in favor of increasing the debt ceiling is different from the one pushed by Treasury Secretary Geithner, which was that if the United States can’t pay any of its bills and increase its borrowing, the country will default. Daley’s argument rests on the notion that if we fail to increase the debt limit, investors may become worried about the government’s ability to pay them back, in which case they may not continue to invest their capital in the United States government, instead choosing other investments that may be safer or offer higher returns, or they may require a increase in the interest rate they want for the money they lend us. Both of these changes can come about if the perceived reliability of the federal government as a conscientious debtor is put in doubt.

Would a failure to increase the debt ceiling make the bond market nervous? Yes, it probably would, but so would increasing the debt ceiling, in the long run. If the United States doesn’t increase the limit, it will have to prioritize its spending. Not everyone’s obligation would be honored. That would change expectations about U.S. policy going forward. In other words, not raising the debt ceiling would probably introduce some uncertainty.

However, it doesn’t seem right to assume that our investors (especially foreign creditors, who now own a majority of our publicly held debt) haven’t already changed their expectations about the federal government’s long-term ability to pay back its debt, given the increased attention to the debt-limit debate and the strong alarmist language being used by Treasury and the White House.

As the Mercatus Center’s Satya Thallam explained to me recently:

With some signs of life (increases in consumer spending), we could expect declines in demand for Treasury and fixed-income assets. However, the Federal Reserve is still actively purchasing notes, which will likely increase demand. Ultimately, it makes predictions on the effect of interest rates very tricky.

For sure, not increasing the debt ceiling will make us travel to a new equilibrium, which almost always means a certain level of disruption in the short term. But shouldn’t such change be the easiest way to mitigate short-term concerns while moving to a more sustainable long-term equilibrium?

And that leads me to a final point. While the market may react to a failure to raise the debt limit, it would react also if we raise the debt ceiling. I find it interesting that those out there who are worried about default don’t realize that our ability to stave off default depends not on our willingness to raise the debt ceiling but on our continued ability to pay the interest on our debt. As long as we continue to run deficits, our ability to borrow money cheaply, with low interest rates, is key to avoiding default. Yet the more we borrow, the more we signal investors that we are becoming increasingly unreliable and risky. This can’t be ignored.

And in spite of Geithner’s threat, the American people understand that there is a difference between not being able to borrow more money and defaulting. As long as you keep paying your mortgage every month on time, your bank doesn’t care that you have to cut down on your family’s budget. The same should be true for our investors and the federal budget.

Does it mean that the federal government will have to cut spending? Yes, absolutely. And while it may not be fun, it can be done. With tax revenues expected to be $2.2 trillion in FY2011 and interest payments — the part that must be paid to not default — at roughly $300 billion, that still leaves $1.9 trillion left in revenues to pay for our most important priorities. Lawmakers would have to choose what items must be paid today and which ones could be put on the back burner. What matters is that it can be done. (I made that case on Bloomberg TV yesterday.)

Interestingly, Sen. Pat Toomey has argued that he would refuse to raise the debt limit and then would avoid default on the national debt by requiring interest on the debt to be paid first out of revenues, before money is spent on any other programs. He wrote in the Wall Street Journal recently that “I intend to introduce legislation that would require the Treasury to make interest payments on our debt its first priority in the event that the debt ceiling is not raised.” I am curious to see how many members of his party he can convince.


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