Five Lasting Lessons From The Debt Ceiling Debate

Financial Armageddon will not arrive today. The debt ceiling compromise that President Obama and congressional leaders finally reached over the weekend will hold, and the United States will give itself permission to borrow enough money to pay its bills.

Like all big stories, this one will eventually drop off the front pages and the nightly news, as well as their electronic equivalents. This one should have better legs than most, however, if only because the bipartisan, bicameral congressional über-committee that is supposed to find at least $1.5 trillion in additional spending cuts will command a lot of attention through the remainder of this year.

Though the headlines will slow and ultimately stop, this is not one of those stories that quickly fades from collective memory. The debt ceiling drama was, in many ways, an actual drama – a political and policy play performed on the world stage, with conflicted characters and a story arc that reached a dramatic peak. It brought arcane principles vividly to life in ways that will stay active, at least in the world’s subconscious, for a long time to come.

The debt debate offered many lessons. Here are five that I think are among the most important, and those most likely to have a lasting impact on future decisions even after people have forgotten the details of the past few weeks’ negotiations.

1. The myth of the Social Security trust fund is gone forever. Obama may have been bluffing when he hinted that Social Security payments might not go out as scheduled tomorrow if the debt ceiling were not raised by today, but his underlying point was true: The government has no liquid reserves to pay Social Security, Medicare, or anything else. Social Security is not, and never has been, a pre-funded retirement plan through which you and your employer fund your own future benefits. Its trust fund is nothing more than a pile of government IOUs, and is therefore just one claim among many against the federal purse. Had push come to shove this week, the first people who would have been paid would have been Treasury debt holders, because a default on those obligations would have had immediate and catastrophic consequences to the government and the global economy. Social Security recipients probably were next in line (the White House refused to release its contingency plans), although in a future crisis, they may stand further back. None of this is news. But the fact that we came so close, so soon, to not paying Social Security is likely to finally serve as an impetus to change the program. Either we recognize it for the welfare system that it is, or we should at least make part of it truly self-sustaining, which is another way of saying we should have privately-owned and funded Social Security accounts.

2. The United States no longer controls its own financial destiny. It takes two more or less willing parties to make a loan. Refusing to raise the debt ceiling would have eliminated the willing borrower from the equation. What happens if the willing lenders walk away? Exactly the same thing that might have happened today. Without willing lenders, Uncle Sam could not pay its bills, just as it could not have kept the checks going out without a boost in the self-imposed debt ceiling. We assume that a mild downgrade of the national credit rating will not eliminate willing lenders, only make them demand somewhat higher interest rates. That is not how things always work out. Nobody wants to be the last to know when there is a run on the bank. At some point, not of our choosing, lenders may simply decide they are unwilling to lend to us at any rate we are willing or able to pay. This is what happened to Greece. But we would be worse off than Greece, which could ultimately call on larger nations in the euro zone for help. If the United States got into a credit crunch, it would literally take the entire world to cooperate to organize a bailout. Good luck with that.

3. China has to grow up. The Chinese have been free-riding on their “developing” country status, but they are discovering that the ride is not truly free. American fiscal troubles have immediate repercussions in Europe or Japan when their currencies appreciate against the dollar. The Chinese, to preserve their exports, manage their currency and capital flows to slow the yuan’s rise against the dollar, which actually allows the yuan to fall against the currencies of other Chinese trade partners. As a result, China is piling up trillions in reserves that it can find no place to invest, except in U.S. Treasury debt. This is why the Chinese were horrified at the prospect of a U.S. default. China is, in fact, a developing country, with an economy about half our size despite having four times our population. But when China reaches just a quarter of our productivity, its economy will equal ours; when the Chinese output per worker reaches half of ours, their economy will double it. To protect its own interests, China needs a convertible currency that prices its goods at what they are really worth. I think we will see the Chinese move sharply in that direction within the next decade.

4. The political center still exists, but it moves. The weekend compromise will satisfy neither conservative Republicans, who want to arrest the buildup of national debt, nor liberal Democrats, who think wealthy Americans benefit more from the current tax system than the roughly half of the population who expect to receive more in lifetime federal benefits, including Social Security and health care, than they will ever pay in income and payroll taxes. In between the two extremes is a group that wants to avoid catastrophe now and minimize pain later. In 2005, when President George W. Bush wanted to reform Social Security, the political center was not ready to touch entitlements and his proposal was stillborn. Now, even President Obama acknowledges the need to change entitlements, while House Budget Chairman Paul Ryan, R-Wisc., has already proposed a major restructuring of Medicare. The political center does what has to be done, but it often waits until the last minute to do it. The center seems to be getting ready to finally tackle the big issues. That is good news.

5. There is no riskless asset, and the United States is not a AAA risk. The American credit rating agencies may soon acknowledge what is plain for the world to see: a country with combined federal, state and local debts well above its annual national output, with large and often poorly quantified unfunded obligations, with few effective cost controls on its health care and an aging and slow-growing population, is not a AAA credit risk. Any other nation would have lost the gold-plated credit rating already. There are two reasons why America has not. One is that the debt is entirely denominated in our own currency, so in a technical sense we can avoid default by printing the dollars to pay our obligations – though we would so devalue the dollar that this would break faith with everyone who holds our debt and our currency. The other is that the U.S.-based agencies simply have a home-country bias and cannot conceive of a world in which the United States and its dollar are not the lynchpin of the global economy.

Maybe a credible plan to reform entitlements and bring long-range national spending in line with the nation’s commitments could salvage the AAA rating, but I don’t think so. Already, our debt is so large that a rise in global interest rates – which we cannot control – would blow a hole in almost any fiscal stabilization plan. This risk alone ought to be reflected in a downgraded rating. It is probably just a matter of time. Once this happens, the world will have to adjust to the idea that the “risk-free” Treasury interest rate we studied in business school is not risk free, and that there is no replacement. This realization is ultimately healthy, because it reflects reality and should help markets price capital more appropriately, but along the way we are going to have to adjust to more expensive credit.

Add it up, and the takeaway from the debt ceiling debate is that the system is trying to correct itself before things get out of control. There is a reasonably good chance that it will, but the final act of this drama has yet to be written.

About Larry M. Elkin 534 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

3 Comments on Five Lasting Lessons From The Debt Ceiling Debate

  1. Willing lenders is a good point.

    Of the current 14 trillion, China holds maybe 1 trillion.

    But… SS Trust fund holds close to 3 trillion, and is demographically becoming not only an unwilling lender, but a demanding borrower.

    Over the next few decades, if we want to grow via growing debt, we not only need to find new lenders, but fill in the significant double whammy hole created by the exit of the SS Trust fund as willing lender and replacement as demanding borrower.

    Said another way, what doubly felt so good when we were doing the blind borrowing is going to doubly feel so bad when it inverts.

    • Ok, let me get this straight…We borrow from Peter to pay Paul because the cookie jar is empty and now we need Fred to tell us how much we should quit spending because we don’t have the ability to refill the cookie jar without borrowing more money we can’t pay back from Tom, Dick and Harry who may or may not want to lend us any more $ unless Santa Claus says we are good for it…REALLY?
      God help us all!

  2. You state that we must recognize SS for the welfare system that it is–Yes it is, welfare for the federal government. Under law the SS trust must invest its holdings and also by law can only invest in the treasury (US debt). How’s that for a internal welfare system.

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