The Debt Limit Drama

The US Government debt reached the highest limit of $14.3 trillion on May 15, 2011. The government’s budget deficit this year alone is set to be a record breaking $1.5 trillion. It is estimated that two dollars of every three dollars it spends are borrowed. In relative terms, if an individual’s income is $100,000 per year, it means that he is spending $160,000 per year and adding $60,000 per year to credit card debt which already stands at $650,000 [1]. If the limit is not increased by August 2, 2011, there is a possibility that US will default and would be forced to stop paying its creditors – from bond investors and contractors to some government salaries. It is estimated that the social security and health care programs are in $43 trillion deficit. To cover this, the government would have to eliminate virtually all other spending or significantly increase the tax rates. However, raising taxes is a double edge sword. In addition to political issues, it can lead to reduced disposable income and consumer spending which will derail the economic recovery. After the 2008 financial meltdown, the unemployment rate climbed to10%, and even after 3 years is in the range of 8-9%. Even after keeping the key interest rate at a historical low (nearly zero), the economic recovery has been slow and sporadic.

Since 1962, the debt ceiling (the amount the government can borrow) has been increased 72 times. Repeating the same act for 72 times without proper long term strategic planning certainly indicates failure. There is a need to tackle the problem at the root cause. Factors affecting the deficit must be addressed instead of just raising the debt limit as and when money is required. One view of the situation is that the short term fixes gives Congress the reason to slash unnecessary spending programs. Another view is improper decision analysis. Decisions based upon the spending levels of previous years ignores the current situation: health care cost, the creation of the Part D drug benefit, increased homeland security spending post-9/11, wars, aging American population, increased social security and Medicare expenses and low tax revenue. On the other hand if the debt ceiling is not increased the consequences will be fatal. The government may default on its obligation to the creditors. The US might lose its highest credit rating. Standard & Poor forecasted a negative-outlook for U.S. debt and stated that there is a 33% chance of a credit downgrade within the next two years. The interest rates may rise which in turn will increase the cost of borrowing for the government.

It is predicted that the Congress will indeed increase the limit but will wait till the last moment. In my opinion, this is a better option than allowing the nation to default. However, there needs to be radical reforms and sustainable recovery plan. Four detailed outlines have already been discussed in the past five months, two by bipartisan commissions, one by the President and one by House Republicans. Focus should be on a long term strategy to reduce debt instead of the short term fixes and continued borrowing. The short term view will inevitably continue the vicious cycle of changing the legislation to increase the debt limit. Fundamental assumptions within the restructuring plan must be questioned. The plan should be based on current data and not the merry yester year economic indicators. A thorough restructuring plan will ensure that the nation is back on the road to financial security and prosperity.

References:

1. Solving America’s Debt Problem, The One Cent Solution, Stewart Welch III, 4/25/2011.

2. For public, debt limit fight risks dangerous game of chicken, USA Today, 4/28/2011.