The Higher the Debt Ceiling, the Deeper the Hole

When some newly elected members of Congress declared their resistance to increasing the nation's debt ceiling earlier this month, it set off a firestorm of frenzied warnings that a refusal to raise the limit on the U.S. debt would trigger financial Armageddon.

For example, Austan Goolsbee, the chairman of the president's Council of Economic Advisers, said in an interview on ABC's This Week, "If we hit the debt ceiling, that's essentially defaulting on our obligations, which is totally unprecedented in American history. The impact on the economy would be catastrophic."

Treasury Secretary Timothy Geithner weighed in with a warning that failure to raise the debt ceiling would have "catastrophic economic consequences that would last for decades." According to Geithner, the national debt is currently $13.961 trillion, and the legal limit for government borrowing was set by Congress last January at $14.29 trillion.

But shrill predictions of impending doom don't shed much light on the issues raised by the debt ceiling issue, which could have serious long-term consequences for all Americans. So let's start with the basics of the nation's fast-rising debt, and why Congress has to keep raising the debt ceiling every year.

Playing Political Chicken

Federal debt is subject to a statutory ceiling -- a limit -- that's set by Congress. If the national debt hits the ceiling, the Treasury would be barred from borrowing more money. Since the federal government borrows an average of $125 billion a month -- roughly $1.5 trillion a year -- a freeze on borrowing would mean that some of the government's bills could not paid, for example, Treasury bondholders' interest, entitlements benefits such as Medicare or other costs of running the government.

The government reached just such an impasse in 1995 when then-President Clinton vetoed the budget approved by the Republican-controlled Congress. For five days, nonessential government services were cut off, and some federal workers were sent home. That shutdown was widely regarded as a political game of chicken in which the two sides essentially dared the other to shut down the government. This posturing did not have any long-term financial consequences for either the government or the nation.

Unfortunately, the same cannot be said of the unprecedented deficit spending that's causing the national debt to skyrocket now: Federal deficits added $1 trillion to the debt in 2008, $1.9 trillion in 2009, and $1.7 trillion in 2010. Given that the 2011 fiscal year deficit is expected to exceed $1.3 trillion, by the end of fiscal year 2011 in October, we will have added over $6 trillion to the national debt just since 2007.

What We "Owe" Ourselves -- and Others

With expenses of roughly $3.8 trillion and revenues of around $2.3 trillion, the federal government has been borrowing an astonishing 40% of its budget every year. It should thus come as no surprise that the Government Accountability Office has issued a report, A Citizen's Guide to the 2008 Financial Report of the United States Government, that called the nation's current borrow-and-spend path fiscally unsustainable.

Not only are age-based federal entitlements like Social Security and Medicare set to continue rising far faster than either the economy (as measured by GDP) or tax revenues, but the interest paid on the ballooning debt will rise as well. That could potentially crowd out other program spending if interest rates rise -- a trend that's already evident as governments worldwide borrow unprecedented sums to fund their deficits.

To get a handle on the interest payments, one must first understand that there are two kinds of national debt: that which is "held by the public" -- which includes Treasury bonds owned by non-U.S. investors and central banks in places like China and Japan -- and "intragovernmental holdings," bonds held by the Social Security Trust Fund and other federal agencies.

The government has long "borrowed" surpluses from Social Security tax revenues and deposited IOUs in the trust fund. The interest the Treasury pays on the IOUs is in effect "money we owe ourselves."

But the interest paid on T-bills "held by the public" is money that must be paid out of tax revenues or borrowed. In the decade since 2001, this so-called "external debt" has tripled from $3.3 trillion to $10 trillion.

With interest rates scraping historic lows, the annual interest the Treasury paid in 2010 was about $200 billion -- a sum only exceeded in size by the budgets of Defense, Social Security and Medicare -- the two largest federal programs.

Can't Grow Our Way Out of High Debt

If deficits continue at the current pace, by 2014, the external debt will be a gargantuan $15 trillion. If interest rates were to rise from current lows to historic averages, annual interest payments could equal or exceed the budgets of Defense and Social Security. Interest payments on this scale would crowd out other spending, and potentially push up both taxes and borrowing, making future debt payments even more onerous.

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The total national debt -- which includes the "intragovernmental holdings" -- has more than doubled in the past decade from $5.7 trillion to more than $14 trillion -- roughly 97% of the nation's GDP.

That number is approaching the relative levels of debt that burdens the economies of such nations as Greece (130%), Ireland (93%) and Portugal (97%), whose fiscal woes triggered the ongoing eurozone debt crisis.

Deficits of this magnitude, fully 11% of the nation's annual GDP, far outpace economic growth, which typically meanders between 2% and 3% annually. The two are related: Economists Carmen Reinhart and Kenneth Rogoff found that nations with debts exceeding 90% of GDP saw their growth rates cut in half. Their conclusion: Nations rarely "grow their way" out of rapidly rising debt.

Are Our Woes Cyclical or Structural?

Author and blogger Michael Panzner recently summed up the critical issue buried in America's yawning deficits and skyrocketing debt. Federal authorities have poured trillions of dollars into the financial sector and borrowed trillions more to fund historically unprecedented deficits, all in the faith that this was a cyclical downturn which would soon end.

But as federal deficits stubbornly remain at the $1.5 trillion level, year after year, the question becomes: Is this is a structural downturn rather than a cyclical one that we can borrow and spend our way out of?

If we're in a long-term structural crisis, then borrowing trillions more every year is only digging a deeper hole for the future.