Perhaps debt can be perpetually financed

By DAVID MOON, Moon Capital Management, LLC
July 17, 2011

A University of Tennessee finance instructor once told me that, unlike individuals, corporations and governments in developed countries could perpetually refinance their debt.

After earning his PhD, I’m guessing this young man went to work for a Federal Reserve bank or a quant fund on Wall Street – at least until the credit crunch of 2008. If there’s any justice in the academic world, he’s now a teacher’s assistant in a 9th grade Home Ec class in BumFlip, Alabama.

I’m guessing that Professor BumFlip never gave much thought to the federal debt limit.

Prior to 1917, the US government operated much like your family. It had revenue and expenses. Occasionally it had some need (or desire) to spend more money than was available from its current income stream, so it would borrow money. Like borrowing money for a car, house or vacation, Congress would approve a specific bond issue for a specific purpose.

If Congress needed cash to pay soldiers to fight in the Civil War, it borrowed money for that purpose.

With the first World War, that process was no longer efficient. The US was borrowing money at a torrid pace. Legislators couldn’t reasonable debate and approve a specific bond issuance for each tank or shipment of machine guns.

So in 1917 Congress gave the Treasury Department the authority to borrow money up to a certain level without prior legislative approval. It was like giving a teenager a credit card with a limit.

The debt limit has been raised regularly in the subsequent 94 years, often with as much drama as we are witnessing this year.

As the US repeatedly approached the statutory debt limit in 1950, Congress would simply approve a temporary waiver of the requirements of the debt ceiling. They just voted to ignore the law for a little while.

Why is that no surprise?

In 1995, there was a debt limit situation that rivaled today’s political theater. The Treasury Secretary cancelled security auctions and dipped into government retirement plans for cash needs.

A similar contrived crisis was miraculously resolved in 2002, using many of the same tactics and gimmicks as in 1995.

These emergencies are not new. What is new is that we are reaching a mathematical tipping point that the politicians may not fully appreciate, however.

We have no choice but to increase our federal debt today. The US must borrow more money each year simply to pay its bills. Unlike a family that can choose not to borrow money to buy a new boat or larger house, the federal government is borrowing money to buy groceries.

There are three ways to solve this problem: A traditional default on our national debt, which creates infinitely more problems than it solves; a massive cut in federal spending, which is a practical political impossibility; or a massive increase in taxes – either explicit (the April 15 kind) or implicit (the inflationary kind.)

And while arguing over the explicit taxes, expect the implicit ones to begin to increase, along with our debt.

Perhaps that finance teacher was right.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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