The Budget and the Debt Ceiling

Treasury reported a $439 billion budget deficit for the fiscal year ending in September. That sounds like a lot, but it’s 2.4% of GDP, below the average of the last few decades. However, that’s nothing to celebrate, as the retirement of the baby-boom generation will boost entitlement spending in the decades to come. There’s plenty of time to solve that problem, but the federal debt ceiling is a more immediate concern. Congress has just two weeks to work out a deal.

The deficit ballooned to $1.4 trillion (10% of GDP) in FY09, reflecting the severity of the recession. Revenues dried up, and recession-related spending (unemployment benefits, food stamps) surged. As the economy recovered, spending retreated and revenues recovered (although not entirely – the economy remains below its potential). We did have some fiscal stimulus at the beginning of the recovery, about $831 billion spread out, mostly in 2009 to 2011. That was small compared to the magnitude of the decline in GDP (and more than 40% of the stimulus was ineffective tax cuts in the first two years).

Medicare and Social Security are accounting for an increasing share of federal outlays. Nondefense discretionary spending (outlays less defense, entitlements, and interest) is now about 3.3% of GDP, but is projected to fall steadily over time (so contrary to popular misconceptions, if you exclude entitlements, there’s not a whole lot of the budget to cut). Medicare is the bigger problem, reflecting healthcare cost inflation on top of the demographic issues. The government will eventually have to face the necessity of cutting entitlements, raising taxes, or borrowing more (or, most likely, some combination of these).

Under the Constitution, (Article 1, Section 8), only Congress can authorize federal borrowing. The federal debt is simply the sum of past budget deficits. Congress established the debt ceiling in 1917 as a means of preventing President Wilson from spending too much on World War I. We haven’t been able to get rid of it since, even though it may be at odds with the annual budget set by Congress. Often, one party will try to use the debt ceiling to extract something that it wants from the other side. This is politics. Senator Obama voted against raising the debt ceiling. Many Republicans had no problem raising the debt ceiling several times during the previous administration.

In 2011, a debt ceiling crisis led to a downgrade of U.S. debt. That downgrade did not have much of an impact on Treasury bond yields, which declined. However, the uncertainty did contribute to a 2000-point drop in the Dow.

The debt ceiling had been suspended, but went back into effect in mid-March. Treasury has extraordinary measures (borrowing from certain government retirement funds) to artificially stay below the limit, but now projects November 3 to be the “drop dead” date for raising the debt ceiling. House Speaker Boehner, who resigned effective October 30, can still work with House Democrats to come up with a compromise, but we are running out of time quickly and need to see some action.

© Raymond James

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