Moody’s stepped into the deficit debate today by suggesting that the US should get rid of the debt ceiling altogether. This suggestion makes some sense but isn’t exactly the best mechanism for determining what the debt ceiling should be at any given time.

For example, during World War II, the debt in the US spiralled to almost 130% of GDP. The traditional level however has been below 50% when looked at across the last century or more. This is in keeping with the Maastricht criteria which provide a recommended cap of 60%.

Dr. William Edwards Deming is widely regarded as the father of total quality management – a system of statistical control in which quality is a practice of continual improvement where manufacturing is thought of as a system, not as bits and pieces. By doing so, your fundamental measures of quality can be bounded. It is not the individual measure at a point of time that is important but rather does that point lie within the those bounds.

In this case – the measure is the percentage of debt verses GDP.

If you remove special cause of variability, for example capital spending on World War II, then what you get is a graph which is more or less consistent with D/GDP being in the 20%-70% range. Under normal circumstances, the debt shouldn’t rise above these levels.

Unfortunately, when Bush left office in 2008, he saddled the US with a whopping deficit obligation which was impossible for any President to back away from. In short, G.W. Bush took the system out of statistical control and Congress rode on those coat tails to push it the rest of the way. There were no extraordinary crises which would have mandated these measures if the Government had been doing its job through regulatory policy and putting the health of the nation first.

Being consistently in the upper range of the D/GDP boundary is a clear signal that something fundamental has changed and that it needs to be looked at. Not after the Debt has ballooned to 90% or more of GDP. Clinton knew enough to bring those ratios down.  Bush was the maker of his own ‘crises’. But this just goes to shows what happens when you put personal agendas ahead of managing the economy to weather a real crisis when one comes along.

Which gets back to this original point of the debt ceiling level.

If the normal boundaries for government expenditures are between 20%-70%, then any crisis that pushes the system out of balance should be defined as such by either the President or Congress including the terms by which that problem will be deemed to have been resolved. During those times, the debt ceiling should double which the understanding that it country needs to dedicate itself to the express purpose of getting the economic spending of government back into statistical control with all due haste once that crisis is past. Further, both Congress and the President should be bound by those requirements, superseding all other political agendas.

What is at risk is the US’ ability to address additional crises should one come along.

There are three other points that needs to be made before getting to a resolution on the idea of a debt ceiling.

First – During a crisis, the bills to be paid don’t stop once the crisis is resolved. It will typically take another 2-4 years of increased government spending before the government can be said to have ‘turned the corner’ and can start focusing on real debt reduction.

Second – Governments have typically relied on inflation to reduce the size of the debt compared to GDP by anticipating that, so long as they can cover the interest payments, the size of the debt will shrink naturally. This is because in 10 years time, what cost $100 today will only be worth $60 in 2021. As a percentage of GDP that is huge so long as there is a growing economy. It’s when economies are shrinking or on the verge of collapse that this strategy fails to work.

Third – A crisis is a special circumstance of variation. As such it cannot be systemic. That means that in declaring a crisis, the crisis cannot be on-going – such as the war on drugs which was first announced in the Nixon administration. The ability to declare a crisis means that it must be extraordinary, short-term, and solvable. Anything else is systemic to the functioning of the economic system.

Moody’s point of removing the debt ceiling, while likely practical in the short term, is also short sighted. It removes all restraints which is not good in an era where politicians think money grows on sheep. There needs to be caps in place which are essential trigger points for ensuring the economic health and total quality of the system when looked at as a whole.

Possible Solution

There are three aspects to a possible solution that need to be put in place.

The first is to establish a ‘normalized’ threshold for debt to GDP ratio which is the idealized state, or goal, that both Congress and the President agree to reach. That threshold should be down somewhere in the 20-30% range. Keep in mind that at its peak, WW II raised the D:GDP ratio from 50% to almost 130%, a difference of 80 points. The current financial crisis, has resulted in debt going from 70% to almost 100%, or a 30-point difference. If we can assume the average crisis will therefore take a 50 point increase, then setting a 20% idealized debt threshold means the US could weather almost any crisis short of another world war while keeping the economy vibrant and healthy.

The third is to define the terms and conditions of the crisis at hand which would allow the debt ceiling to be raised from 70% of GDP to 140% of GDP. Similar to establishing a project charter, Congress and the President would need to define what the crisis is and the conditions that need to be satisfied in order to declare the crisis over.

The third is to establish a rule that requires both Congress and the President to enact spending measures that reduce the debt, in real terms, every year starting no more than 4 years after the crisis has been solved. Budgets must continue to be passed which lower the debt ceiling year over year until the debt falls to below 70%. That means the debt ceiling would change from year to year based on the previous year’s spending. Once it is back into a steady state, the restriction comes off and Congress and the President can get back to their normal bickering, finger-pointing, and backstabbing as per usual.

This to me seems to be far more reasonable than the ‘quick fix’ proposed by Moody’s and would be far more fiscally responsible.

— Kevin Feenan