Related links: http://www.richmondfed.org/publications/research/region_focus/2010/q1/policy_update_weblinks.cfmBudget deficits

Stephen Slivinski

English

Research Papers in Economics

10 R e g i o n   F o c u s   |   Fi r s t   Q u a r t e r   |   2 0 1 0  
O
n February 12, President Obama signed into law a
$1.9 trillion increase in the federal debt limit. The
new debt limit sits at $14.3 trillion.  
Over the past year, lagging revenue and spending pro-
grams  created  to  shore  up  the  banking  system  and  to
respond to various other elements of the recession spurred
the issuing of new Treasury debt for auction to the public.
The amount of outstanding federal debt subject to the limit
was rapidly closing in on the $12.4 trillion cap at the time the
president  signed  the  increase.  If  the  limit  had  not  been
raised, the Treasury would have had no legal authority to
issue additional debt to finance the spending. 
An immediate consequence of not raising the debt limit
is that it could cause operational problems, such as an inabil-
ity  to  pay  for  the  day-to-day  expenses  of  government
agencies,  which  might  spur  disruptions  in  a  variety  of 
federal programs. A potential but arguably improbable out-
come is that the federal government could default on debt.
That could result in a loss of confidence by investors in the
U.S. government and sharply raise the cost to the govern-
ment  of  financing  debt  in  the  future  as  lenders  demand
higher interest rates to compensate for new risk. 
How likely these outcomes might be is open to debate.
For instance, it’s quite unlikely that pressure to raise the
debt level would be resisted by policymakers. Since the late
1950s, the debt limit has been raised by Congress approved
by the president almost every year except in the five-year
span between fiscal years 1998 and 2001. Those were years in
which the federal government actually ran budget surpluses
and didn’t need to issue any debt. In fact, the government
was able to buy back some bonds and marginally reduce its
debt load.       
The genesis of the debt limit can be found in the Second
Liberty Bond Act of 1917. This law allowed the Treasury to
issue long-term debt to finance the military expenditures of
the United States during World War I. 
Before the war, Congress would have to authorize specif-
ic loans or debt instruments on a case by case basis, as when
it  approved  the  debt  to  build  the  Panama  Canal,  for
instance. The limit in the act applied to both certificates of
indebtedness and Liberty Bonds. This was meant to allow
some discretion and flexibility to the Treasury to meet its
needs. 
In the next two decades, however, Congress would pass
separate limits on other categories of debt that included tra-
ditional Treasury bonds. In 1939, Congress eliminated these
separate limits and created the first aggregate limit that cov-
ered nearly all federal debt. 
The debt limit as we know it today covers publicly held
debt — bonds that are sold by the Treasury at auction and
are purchased by foreign governments and individual private
investors, just to name a few. The federal government can
also hold debt that is subject to the limit. Since the mid-
1980s, the Social Security program has collected more in
revenue than it has paid out in benefits. This surplus has
been committed to current spending on other programs by
Congress. In its place, Treasury bonds have been issued to
the Social Security account. 
Some argue that a debt cap so frequently raised hardly
seems like a constraint. The importance of fiscal restraint,
however, isn’t always absent from the minds of some policy-
makers. Some of the legislative debate over the recent debt
limit  hike  centered  on  the  need  to  restrain  the  rates  of 
government  spending  and  to  limit  the  amount  of  new 
debt needed. But a number of amendments to place some
constraints on the budget process were voted down.
Many analysts argue that debt levels should be viewed in
relation  to  the  size  of  the  economy. Today,  debt  held  by 
the  public  is  equal  to  about  60  percent  of  GDP.  The
Congressional Budget Office (CBO) estimates that, under
current policies, the level of publicly held debt could reach
66 percent of GDP by 2020. Enacting new spending propos-
als in the president’s budget could increase that figure to 90
percent in the next 10 years, according to the CBO. In con-
trast, that figure never rose above 50 percent between 1970
and 2008.  
Others argue that the important number to keep in mind
is the amount of interest the federal government needs to
pay on the national debt. As long as the interest rates on the
bonds — the cost of carrying that debt — are low, there will
be  less  real  fiscal  strain.  Today  the  interest  on  the  debt 
equals 1.4 percent of GDP. Even in the worst-case scenario
currently  projected  by  the  CBO,  that  figure  will  equal 
3 percent of GDP in 2020. 
Many observers also note that the high cost of federal
benefits to be paid to retirees in the future should be cause
for concern. As members of the baby boom generation begin
to retire, the money to fund their benefits will have to come
from the current revenue stream because the Social Security
accounts are filled not with cash but with Treasury securi-
ties.  Pressure  to  issue  even  more  debt  or  to  raise  taxes 
will likely increase. An alternative would be to cut benefits
or  raise  the  retirement  age,  but  it’s  unclear  how  those 
proposals would fare politically. 
If  the  past  is  an  indication  of  future  political  will  to
restrain budget deficits and maintain the debt limit, we may
be in for much higher debt levels — and higher debt limits
— in the years to come.  RF
POLICYUPDATE
BY   ST E P H E N   S L I V I N S K I
Federal Debt Limit Raised to Cover Shortfalls

Policy update : Federal debt limit raised to cover shortfalls

http://www.richmondfed.org/publications/research/region_focus/2010/q1/pdf/policy_update.pdf

Policy update : Federal debt limit raised to cover shortfalls

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Research Papers in Economics