25 Fiscal Lessons
Learned over the course of 25 years, paving the way toward a better economic future.Read the Lessons
The original purpose of creating a statutory debt limit in 1917 was not to prevent the government from running up too much debt, but to remove the requirement that Congress authorize individual issuances of debt. The intent was to help ensure that sufficient and timely credit would be available to finance World War I.
One hundred years later, things are very different. The main use of the debt limit now is to prevent the government from paying its bills on time, putting the nation’s creditworthiness at risk and threatening a global financial crisis.
Twice in recent years, 2011 and 2013, the nation was needlessly driven to the brink as policymakers debated over conditions for a debt limit increase in order to avoid a partial default on government obligations.
Financial markets, government creditors and the public looked on with increasing horror and frustration. Yet, there is no guarantee that similar brinkmanship on the debt limit will not be used in the future.
If we want to move beyond episodic crisis management and back to rational budgeting we should recognize that the debt limit has itself become part of the problem.
It begins with a basic misunderstanding of what the debt limit does. Many people naturally assume that a “debt limit” actually exerts control over the nation’s fiscal policies. It does not.
Unlike budget process mechanisms such as caps on appropriations or pay-as-you-go (PAYGO) rules that require spending increases or tax cuts to be paid for, the debt limit places no restrictions on specific tax and spending decisions.
All it does is prevent the government from issuing debt to pay the bills that it has already run up. It’s like trying to curb your personal spending by tossing your unpaid credit card bills in the trash.
Moreover, the limit amount itself lacks any direct ties to the state of the economy or spending and tax decisions. Politicians simply pick a number and then fight about it, turning the congressional budget process into a series of shortsighted makeshift deals cobbled together at the last minute. The pointlessness of this exercise is demonstrated by the fact that neither political party has proposed a budget plan that would avoid further increases in the current limit.
There is a cost to this bad habit. Studies have found that even getting close to the debt limit can cause enough uncertainty in the market for Treasury securities that borrowing costs increase.
As a matter of sound fiscal policy, there is no good reason to have a hard dollar cap on the debt. Washington’s goal should be to first stabilize the debt and then bring it down to a sustainable level relative to the economy. Even if the debt continues to grow, it will become less of a threat if it grows more slowly than the economy.
Following World War II, for example, the debt was $242 billion and 106 percent of GDP. By 1974, the debt had grown in dollar terms to $344 billion but had shrunk to only 23 percent of GDP.
Some argue that the debt limit provides useful leverage to extract fiscal reforms that would be hard to enact otherwise. However, this is ultimately a “trigger” that must never pulled, so it’s of limited value. Furthermore, it comes with the risk that it might go off accidentally.
Refusing to pay the nation’s bills would damage the nation’s creditworthiness and economy while doing nothing to address the underlying mismatch between federal spending and revenues that is producing higher debt.
If politicians want to reform the debt limit so that it might do some good, they could come up with a way to tie the nation’s debt to an economically relevant standard such as the growth rate of the economy. They could also align debt limit increases with the policy decisions that require more borrowing. For example, the House used to follow a rule that packaged debt limit increases with votes on budget resolutions. This procedure ensured that the additional debt incurred under the budget resolution was approved alongside it.
Now that the debt limit has simply become an opportunity to provoke a crisis, it would be best to scrap the current system. The real solution to unsustainable debt is not to risk default but to enact more fiscally responsible policies in the first place.