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How High Should The Debt Ceiling Be Raised?
By Steven Pollack
Jun 5, 2006, 15:50

Once again the U.S. Debt has reached its statutory limit, this time $8.14 Trillion.  And once again the defenders of deficit spending try to minimize the fallout by explaining that as a percentage of the U.S. economy ($12.5 Trillion) the debt is only at about 65%.  They point to problems third world countries run into when debt reaches 150% of the country's production and argue that we are therefore in pretty good shape.

Besides the misdirection of comparing our economy to the default stage of third world countries, there is a general flaw to comparing the debt to the production capability of the economy in the first place.  The economy can never apportion its entire output to paying off old debt so the comparison fails to give any useful advice to policy makers.

It is like saying that you can pay off your personal credit card because the company you work for has gross sales well in excess of what you owe.  Your company has no more intention of devoting its total output to your debt than U.S. economic output will be used to satisfy the public debt (and remain a capitalist economy).  Instead, we should be comparing at the cost of the debt (interest) to the size of the paycheck (the federal budget).

This is much more useful in determining the sustainability of the debt because only so much of economic output can be devoted to federal spending, including debt service, before there are negative effects on the economy.

Federal Budget Item	FY2005	FY2006	2006 @ 8%
Federal Debt	7,871	8,578	8,578
GDP	12,290	13,030	13,030
Total Federal Budget	2,472	2,709	3,176
Interest (debt*interest rate)	184	219	686
Analysis
Federal Budget as a % of GDP	20.11%	20.79%	24.37%
Interest as a % of Federal Budget	7.44%	8.08%	21.60%
Simple interest rate (interest/debt)	2.34%	2.55%	8.00%

Interest rates are at 20 year lows and this masks the real changes in the relationship that have occurred between the debt and the ability to service that debt since Bush Jr. took up the deficit spending of conservative hero Ronald Reagan.  Interest on the debt as a percentage of the budget is directly related to the rate of interest the government pays.  When (not if) interest rates start to rise, the federal budget with be negatively affected.

At an 8% interest rate, the prime rate would likely be 12% to 14%.  This is certainly not unprecedented in recent history.  Applying this rate to the 2006 economy, the above chart shows what this day of reckoning looks like in today's terms.  Interest service on the U.S. debt would be an additional $467 Billion.

This would immediately force a decision whether to increase federal spending or decrease other federal programs.  I have never seen the kind of congressional backbone, from either of the two major parties, that would face down constituents to cut spending programs.  So the reality is that federal spending would increase by the additional amount of interest.  The next question would be whether to raise taxes to pay for the additional spending or to heap it on top of the debt by adding it to the deficit.

Mind you, this $467 Billion deficit is in addition to the current $300 Billion deficits being run under Bush Jr.     Assuming this interest deficit was added to the ongoing budget deficit, an additional $767 Billion would be added to the U.S. debt each year. It would quickly become obvious to holders of U.S. bonds that the U.S. had lost the ability to service the debt and would sell their holdings unless compensated with higher rates.  Higher rates, of course, are what triggered this problem and this could easily become a downward spiraling cycle of higher rates and higher deficits.

This debt-doesn't-matter philosophy follows in the thinking of Reagan-omics.  This is a wrongheaded and politically self-serving way of thinking because debts do matter and the day of reckoning is close at hand.