Oftentimes, politicians will compare the government’s finances to a family, noting that “your family can’t spend more than it takes in year after year; at some point, you have to balance your checkbook.” This is a bad analogy; a better one would be to compare the government to a corporation, but even that falls down in one key area.
Continuing with the Debt Ceiling Q&A:
Allright, how do corporations deal with debt?
Most business entities, from the smallest to the largest, routinely borrow money to finance both short and long term present and planned expenditures. For example, a farmer will borrow money from the local bank to buy seeds for this year’s crop, hoping the rains will come and he’ll sell enough corn or soybeans to pay the loan back, with interest, and have enough to live on. A camera store owner or clothing retailer will borrow money to buy inventory for the fall and Christmas seasons. A large company will borrow to purchase computers, or pay for training for its workers. There are standard accounting measures which a CFO can use to determine if a company is extending itself beyond it’s projected means to repay. I’m not going to detail them here, just mention a few for flavor.
The debt/equity ratio compares what a company owns or is worth to how much debt it has. A ratio of 0.50 is a sign of goof financial health. Days of cash on hand is exactly that: how many days of liquid assets does a company have compared to its average daily expenses. A month is bad, 4 months is pretty good. There are other ratios and numbers an accountant or auditor would use to determine if it is safe to borrow more money.
But trying to apply them to a government is a mistake for one simple reason.
What’s that? What makes a government different from a family or a corporation?
Not only is a government theoretically immortal (so is a corporation), but it has a unique ability: it can create more money at will. Corporations and families do “create” money, along with lenders, whenever they borrow. A loan is a promise to repay principle and interest over time, hoping that one will generate, through one’s own effort, more value than he has now. For example, Apple Computer borrows money to finance the research and development needed to create the iPad, and then sells so many that it takes in more money than the expense of developing and building them.
But when you think about it, the sum total of all those loans and promises to repay through increased value is a giant Ponzi scheme. And it only works if there is a way to periodically increase the total supply of money. That’s done by a quasi governmental agency, a Central Bank. In this country, that’s called the Federal Reserve.
Just how does that work?
The Federal Reserve and the US Treasury are two different entities. While the President appoints the Fed’s directors, and they report to Congress, and Congress has set up guidance for their actions, they do not actually “report” to Congress or the President in the same way that, say the Secretary of Defense does. Their ability to create money through various means happens outside of the budget which Congress approves and the President oversees. But without going into details, let’s just say that the Fed can manipulate the money supply in part by purchasing and selling US Treasury notes.
How do they make sure they don’t create too much new “money”? Isn’t that where inflation comes from?
Just as a corporation’s financial officer will look at various ratios to determine if it is safe to borrow, the Fed looks at measures of the money supply, interest rates, and unemployment to determine how to manipulate the loan market to restrain or expand the money supply. Over time, they’ve gotten pretty good at it, and inflation in this country has been managed fairly well for decades.
And this is the other fundamental difference between the Federal government and all other entities – governments (states, cities), corporations, families. The Federal government can create new money at will. Not simply but just “printing money”. but more subtly by allowing loans to proceed across all entities, beyond the capacity of the loaner to actually cover the possibility that no one repays his debts. This is represented by another of those ratios, specific to finance companies, the ratio of outstanding loan value to actual assets owned by the loaner.
Just how does all this relate to the debt ceiling?
A popular idea is to add an amendment to the US constitution requiring the Federal budget to be in balance every year, for the government to not spend more than it takes in (“Balance”). Added to this would be restrictions on how much money the government could take in, based on the country’s overall economic production (“Cap”).
This idea, which seems to rest on common sense (my family has to live within its means, why can’t the government) is both naive and dangerous.
Requiring an annual balancing of the Federal budget ignores fundamental principles of capitalistic economics and business practices. If we want our country to grow economically, and therefore continue to offer opportunities for ourselves and our children to improve our lives, we need to invest in our future. This is no different than a family borrowing money to invest in a college education for its children, or a company to invest in new inventory or R&D.
Back to the original question: what’s gone wrong, and what should we do now?
What’s wrong, I feel, is that we have no way to measure and decide on how much money to borrow at the Federal level, other than to let Congress vote on it. Imagine what would happen if, instead of the Fed, we had to figure out how much money to make available in the economy by holding votes in congress eery so often. Of if corporations did not have standard measures to help them decide whether it was safe to borrow.
We still need and want Congress to set an annual budget, to determine how much to raise in taxes, and what programs to spend the money on. But maybe we need to de-politicize the issue of borrowing limits.
There are measures, refined over the years, to help central banks decide how to manipulate the money supply. There are measures which are commonly held to work in limiting borrowing levels by corporations or families (remember the old saws, “your mortgage payment should not exceed 25 [or 35]% of your take home pay” or “your house value should not exceed 2.5 times your annual income”?). So too economists studying nations’ budgets and history or repayment and defaults are starting to determine ratios of governmental debt to national income, rates of growth in population and employment, etc which are associated with stable national economies.
Congress needs to create a politically appointed but functionally independent body, akin to the Federal Reserve, to study and set limits on the level of Federal debt which can be outstanding. It needs to be given parameters within which to work, such as allowing more borrowing during times of recession, and less during times of growth, what current interest rates are, etc., with consideration given to maintaining desired goals for employment, inflation, and Federal investment.
While I tend to agree with you that a balanced budget amendment is not the right solution, at this point I am hard pressed for an alternative. You suggest a committee “to study and set limits on the level of Federal debt which can be outstanding.” I suspect that would require a constitutional amendment, and one that congress would never agree to.
Congress is mandated to develop an annual budget. And as recently shown, they have not presented a budget in 25 months or so. How can spending decisions be considered and/or made without the basic framework of a budget?
In my opinion, anything less than a balanced budget amendment provides absolutely no hard and fast rules and just allows our elected officials to continue to posture and politic without making the hard decisions as the debt continues to grow.