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Will Raising the Debt Limit Really Help the US economy?

A default would merely curtail government's ability to engage in unproductive activities...

A FAILURE to raise the $14.29 trillion debt limit – which would risk a default on US debt – could cause "irrevocable damage" to the economy and risk a "double-dip" recession and increase unemployment. At least, that's according to a letter from US Treasury Secretary Timothy Geithner to Senator Michael Bennet, a Colorado Democrat, writes Dr Frank Shostak for the Cobden Centre.

Missing or delaying payments on various obligations, including those to businesses for goods and services and bond payments to investors, would result in a massive and abrupt cut in federal spending and aggregate demand, the letter warned.

'The abrupt contraction would likely push us into a double-dip recession', Geithner said. According to Geithner, he is currently using an emergency reallocation of funds so that the government can meet its obligations, including payments to Treasury bondholders.

Those measures are only expected to enable the government to operate normally until August 2 from when it will start defaulting on payments including those on Treasury debt, an event that could trigger chaos in world financial markets. Geithner is of the view that a default or any missed payments would not only increase borrowing costs for the US government but also for average Americans, businesses and local governments.

Now, when a lender transfers his real savings to a borrower he expects to receive his real savings plus interest after an agreed period, i.e. on the maturity date. In order for the borrower to be able to honour his debt he must be able to generate real wealth that will be sufficient to cover the original debt plus the interest.

Government however, is not a wealth generator; it can only engage in a consumption of real wealth. How then does it repay the debt? – by borrowing again. It uses new borrowings to repay previous borrowings.

As long as the private sector is capable of supporting an expanding pool of real savings, this enables true real economic growth to stay in force. As long as this is the case, the government can engage in its endless borrowing game without ever being caught out – note that government borrowings result in the diversion of real savings from wealth generating activities, which in turn only weakens the economy.

Obviously, then, if the ability of the government to borrow is curtailed this means that its ability to undermine the formation of real wealth is also curtailed – so what is wrong with this?

Once the ability of the government's capacity to engage in non-productive activities is curtailed, various activities that are supported by government spending come under pressure – these activities cannot support themselves because they survive through a diversion of real savings from wealth generating activities.

The emerging crisis then is not a crisis of the real economy as such, but a crisis of non-productive activities. On the contrary, now wealth generators will be able to retain more real savings at their disposal and expand the overall real pie.

The major threat to the economy is not failing to expand the debt limit but failing to arrest endless non-productive borrowings by the government.

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Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

Cobden Centre articles

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