U.S. Fiscal Policy and the Debt Ceiling: A Troubling Scenario

Most of us have a limit to the amount of debt we can amass based on our credit history, outstanding debt and annual income.

Prior to 1917, the U.S. government could only issue debt if Congress approved it. Hence, Congress had control over the amount of debt the federal government could accrue. In 1917, Congress passed the Debt Ceiling Bond Act which allowed the executive branch to issue bonds without Congressional approval. Since that time, the debt ceiling has been raised on numerous occasions and very soon the U.S. will be faced with this decision once again. 

The present debt ceiling stands at $16.394 trillion and, while we are only $63 billion shy of that, most observers expect we will hit the ceiling sometime in late February or early March. Although we averted the fiscal cliff recently, the debt ceiling could be as much of an issue as was the cliff. Here's the point. The larger government becomes, the more debt it amasses, the more tax dollars it will require to pay its bills and fund its operations. This would result in a greater tax burden levied on the American people and less capital in the private sector to spend and invest. This scenario would also stymie demand.

If demand does weaken, production could fall along with prices. Hence, unemployment would rise as businesses cut their budgets and a recession could follow. Now I'm not saying a recession is imminent, but if the events unfold as discussed, it is a distinct possibility. To prevent this the Fed continues to buy about $80 billion in mortgage backed securities and Treasuries each month. Of course, lending standards would need to be relaxed further in order to realize the full effect of this latest round of QE. 

As mentioned, the debt ceiling has been raised many times over the years. Reagan raised the debt ceiling 17 times, George H. W. Bush and Clinton each raised it four times, George W. Bush raised it seven times, and Obama has raised it four times. Raising the debt ceiling is not inherently good or bad. However, with the economy growing at such a slow rate and in the absence of a budget, our ability to service the debt is diminishing.

In fact, at least one rating agency has discussed lowering our credit rating once again. In the March 2011 issue of Investment Advisor magazine I interviewed Ken Volpert of Vanguard. Volpert stated that he believed Washington's fiscal policy was the greatest danger to the economy. I wholeheartedly agree.

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