Two remarkable recent events have caused nearly everybody to talk about the state of the federal budget. Those events are: 1) the debate in Congress over whether to raise the debt ceiling, and 2) Standard & Poor’s action of downgrading the U.S. Government’s credit rating from the coveted AAA level. The latter event is alleged to be the cause of much of the recent turmoil in the financial markets.
The debt ceiling is the legal limit on the federal government’s credit card. As every American knows, once you reach the credit limit on your card, it doesn’t work any more. You can’t borrow more money on that card. This summer, the federal government reached the limit on its $14.3 trillion credit card. This prompted a loud and long debate on what to do about further borrowing.
The easy answer for many was to simply increase the debt limit. That would be equivalent to you and I either going out and getting another credit card or persuading our existing card issuer to increase the limit. That’s what most in Congress pushed for, at least at some level. Many liberal spenders in Congress apparently have no concern over the question of how to fund this continued borrowing. Many of the conservatives argue that the growth of federal spending can’t be sustained and the debt must be slowed.
Standard & Poor’s is the financial firm that rates the credit worthiness of corporate and government bonds and notes. This rating provides advice and notice to potential investors as to the quality of the paper they are buying. In April of this year, S&P put the federal government on notice that Washington must begin to get its financial house in order or it would risk losing its top AAA credit rating.
In a memo issued on April 18, 2011, S&P officials stated that unless federal lawmakers agreed on a plan by 2013 to reduce budget deficits and the national debt, the U.S. could put its AAA credit rating at risk. S&P stated that anything less than $4 trillion in cuts would jeopardize the rating.
How Washington Reacted
You would think responsible politicians would take this advice to heart. After all, if your credit card company told you that if you didn’t control your debt and spending, they would raise your interest rate and drop your credit score, you would probably pay attention. But instead of taking actions to get control of the debt mess, Washington did the opposite. It raised the debt ceiling by $2.4 trillion, from the previous limit of $14.3, which was set in February 2012. In other words, Washington just went out and got another credit card.
Even worse, this is the largest single debt limit increase in history. In fact, President Obama has now presided over two such debt limit increases. The first was that signed into law on February 12, 2010, which pushed the ceiling from $12.4 to $14.3 trillion. The second is this most recent action. And it was the most recent action that caused S&P to downgrade the U.S. Government’s credit rating.
The “deal” cut by budget negotiators in Washington allowing for the debt ceiling increase also called for spending cuts. These cuts are supposed to reduce spending by $38.5 billion in the current budget cycle and $2.1 trillion over ten years. Whether those cuts actually materialize or are wiped out by future congressional action remains to be seen. But in any event, those cuts are about half of what S&P was looking for in terms of spending reduction. In other words, it wasn’t nearly enough.
Rationale for Cutting the Credit Rating
On the heels of this debate came Standard & Poor’s actions in early August. The United States has enjoyed S&P’s highest credit rating for about 70 years. This rating ensures that the federal government can generally pay lower interest rates on its bonds and notes because of the lower risk associated with investing in those debt instruments. The AAA rating has made the U.S. Treasury bond historically one of the safest investments in the world.
By lowering the federal government’s credit rating to AA+, the U.S. will surely have to increase the interest it pays to future investors to induce them to buy U.S. bonds. This directly increases the costs to taxpayers of federal government borrowing.
Why did Standard & Poor’s take such action? The firm’s written statement of its actions reads:
The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.
More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011 (emphasis added). See: “United States of America Long-Term Rating Lowered To ‘AA+’ On Political Risks And Rising Debt Burden; Outlook Negative,” Standard & Poor’s Global Credit Portal, August 5, 2011, available here: http://www.washingtonpost.com/wp-srv/politics/documents/spratingreport_080611.pdf
Stated more simply, S&P is satisfied that the politicians in Washington do not grasp the severity of the debt situation in America. Moreover, continued debate without a practical solution is endangering the nation’s long-term capacity to provide for its debts and remain a stable economic haven for investors.
Standard & Poor’s went on to say that it could lower the long-term rating to “AA” within the next two years if we see less reduction in spending than agreed to, higher interest rates, or new fiscal pressures that result in a higher general government debt trajectory…
After decades of unchecked spending and borrowing, the federal government has hit the wall. For years, rational policy analysts have argued that the spending and borrowing trends we’ve been on for decades are unsustainable. But the politicians just don’t listen. Even in the face of a direct threat by S&P in April to lower the U.S.’s credit rating, the politicians and the administration mostly just looked the other way.
In the meantime, taxpayers continue to pay the price for this irresponsibility and foolishness. Worse, our children and grandchildren are now saddled with so much debt one wonders whether they will enjoy anything close to the same standard of living enjoyed by their parents and grandparents.
What is a Trillion Dollars?
During the course of the debate on whether to raise the debt limit, it became apparent to me that most people simply do not understand the scope of the problem. Countless people would say things like, “Doesn’t it make sense to raise the debt limit just to keep the government running then address the spending problem separately?”
My answer: no it doesn’t. You can’t get yourself out of debt by going deeper into debt.
It then occurred to me that people have no grasp of the scope of the problem because people largely have no idea how to put into perspective the kind of numbers that we are talking about. For example, the deal called for about $2.2 trillion in cuts over 10 years, with $38.5 billion in the first year. That seems like a lot. And during the course of the debate, I routinely heard people refer to these proposed spending cuts as “Draconian” or “radical.”
But these numbers must be put into perspective. They need to be presented in terms that the typical American can compare with realistic circumstances, say for example, a family’s annual income and budget.
How can this be done? Look at the federal government’s 2011 income: the number is about $2,100,000,000,000 (2.1 trillion dollars). Because it is very difficult to imagine a number of this magnitude, let’s look at the government’s income, debt and spending in the context of an American family’s income, debt and spending.
To do that, we simply drop the last eight zeros from all the relevant numbers. Imagine that the resulting amounts reflect your actual household budget (or the relative equivalent).
Here’s what you get:
Total annual household income: $21,700 Total annual household spending:………. $38,200 Total outstanding debt:………………… $142,710 Amount of new debt added in 2011: $16,500 Amount cut from the 2011 budget: $385
What this shows is that a family hopelessly in debt has essentially agreed to stop buying coffee at Starbuck’s in order to get its debt problems under control. But this family is spending nearly twice as much as it earns annually. Do you believe that merely cutting out Starbuck’s is a reasonable way to address the crisis this family faces? Do you believe the right way to manage this crisis is to get yet another credit card? The number one sign that a person is desperately in debt is that he is borrowing money to pay existing debt. That is clearly what this family is doing.
Furthermore, this family does not seem to grasp the fact that they cannot overspend by $16,500 per year and ever hope to control the problem. Even if this family cut its annual deficit spending in half, they would still overspend by $8,250 per year. As such, they will never solve the problem. In fact, their crisis will only deepen.
The reason is simple. As their total debt increases and their debt to income ratio grows further out of whack, their credit score drops. That is, the credit agencies that gage an individual’s credit worthiness put potential lenders on notice that you are a greater lending risk because your capacity to repay any loan is diminished.
As your credit score drops, the cost of new borrowing becomes more expensive because you are a greater risk to potential lenders. At a personal level, we know that lenders look at this financial picture to evaluate whether a person is more or less likely to repay a potential loan. A dropping credit score is notice to lenders that they may not get their money back.
This is exactly what just happened to the United States Government. And we need to understand that it was totally self-inflicted by an irresponsible Congress and Administration which have absolutely no regard for economic basics or realities.
Making Matters Worse
When the cost of borrowing (interest) goes up, the amount of money available to fund other spending goes down. Higher interest rates mean that you must now spend more of your income on interest. As a result, your ability to spend on other necessities, such as food, clothing, housing, etc., goes down. Likewise, your capacity to spend on discretionary items such as cable TV, vacations, and the like, also goes down.
At the individual level, here’s what makes matters worse. Because you have less money available to spend to support your lifestyle, you believe to need to borrow even more to keep up the pattern. But you need to understand that it’s the pattern that caused the problem in the first place. You have spent more than you earn to support a lifestyle you cannot afford.
Why should we think this outcome is any different for the federal government? As the government’s cost of borrowing goes up, its capacity to pay for essential functions such as national defense, border security, courts, etc., goes down.
The Nature of the Debate
As we move forward, we need to understand that the debate is no longer about whether the federal government should play this role or that in the social realm. We can no longer engage in conversation that evaluates whether we should add or expand this program or that. We are way past that. The debate is now much more fundamental.
The question is no longer whether to cut, but how much and how often. The question is not whether to increase our national debt by this amount or that amount. In the case of our hypothetical family discussed above, they have no business discussing whether and when to take a vacation, or how much to borrow to do it.
At this point, we need to talk about making moves that will ensure our economic survival. This means, at the very least, there must be two moves made without further delay. First, the federal government must STOP borrowing money. Even though the U.S. increased the debt limit on its credit card does not mean that we have to use it. In fact, the card should be cut up in the form of legislation that reduces the debt ceiling. This will send a clear message to Standard & Poor’s that we are serious about managing the problem.
Second, we must STOP the deficit spending. This cannot wait. The current budget agreement calls for reductions in spending of $2.1 trillion, but over ten years, with just $38.5 billion the first year. Re-examine the chart presented above. As you can see, this kind of spending reduction is a joke and S&P received it as such. Keep in mind that the April analysis issued by S&P expected at last $4 trillion in spending cuts. Congress delivered barely half that amount.
It’s not enough to stop borrowing if Congress does not stop deficit spending. Don’t lose sight of the fact that the federal government can spend more than it takes in by printing money. This is at least as bad as borrowing because that is the very essence of inflation and it’s what causes prices to rise.
Inflation is a hidden tax. It’s a tax in the form of higher prices for the same goods and services. Inflation attacks individuals by cutting into their annual earnings and devaluing their savings. It is particularly insidious because most people blame outside sources for inflation rather than the true culprit, which is and can only be the federal government.
It is my hope that the action of Standard & Poor’s got our attention.
Dan Pilla () is a tax litigation consultant and author of 11 books on IRS defense strategies. He runs the TaxHelpOnline.com Web site.