Balanced Budget Amendment and Government Default

Balanced Budget Amendment Would Significantly
Increase Risks of a Government Default

The constitutional balanced budget amendment would require a three-fifths vote of each chamber of Congress to increase the limit on the debt of the United States held by the public. This provision is supposed to make the balanced budget amendment self-enforcing; for a deficit to occur, the debt limit would have to be increased so that the government could borrow money. If a deficit were allowed to develop without the debt limit’s being raised, the government would default.

In documents explaining the balanced budget amendment that Reps. Dan Schaefer and Charles Stenholm (the House co-authors of the amendment) circulated in November 1996, they state that the debt limit section of the amendment "provides the essential mechanism which not only enforces an honest budgeting process in pursuit of [the balanced budget requirement], but will also operate to make the amendment self-enforcing. [It] is the backstop to prevent the use of gimmicks or other devices to circumvent the requirements of the amendment."¹

In fact, however, this aspect of the amendment is highly problematic. Not only is it unlikely to work as smoothly as its authors predict, but one of its consequences will almost surely be to make crises where a default threatens more frequent and to heighten significantly the risk that default will actually occur.

In late 1995, the nation went through a default crisis, along with the risk of a government shutdown. Such crises should be avoided. But the balanced budget amendment would precipitate such crises and make them harder to resolve.

Until now, resolving such crises required a majority vote of Congress. Even a simple majority has proved difficult to assemble on a number of occasions for legislation to raise the debt limit. Under the constitutional amendment, a three-fifths majority would be required.

The requirement for a supermajority vote to raise the debt limit takes on added significance because under a balanced budget amendment, it is inevitable that there will be a number of years in which the budget is balanced at the start of the fiscal year but slips out of balance as the year progresses due to factors beyond policymakers’ control, such as slower-than-predicted economic growth or revenue collections that come in below the forecast. When that occurs with a good part of the fiscal year gone, policymakers could face a choice between a) exceptionally deep budget cuts or tax increases that would remove so much purchasing power from the economy in the months remaining in the year that they could cause significant economic damage, and b) raising the debt limit. If it were not feasible to achieve budget cuts or tax increases of the magnitude needed to achieve balance in the remaining months of the fiscal year, the only way to avoid a default would be to raise the debt limit. But because that would require a three-fifths vote, it could prove excruciatingly difficult. The result could be a fiscal and constitutional crisis. Such crises could recur frequently.

Exacerbating the problem, the balanced budget amendment would outlaw the measures the Treasury Department used in late 1995 to avoid a default when it took policymakers several months to resolve the impasse that had precipitated that year’s budget crisis. Under a balanced budget regime, default crises thus would be likely to occur on a more frequent basis than in the past, and the risk that default would actually occur would rise significantly.

Furthermore, the debt limit provisions of the amendment would greatly increase the power of minority factions of Congress to withhold the votes needed to amass a three-fifths majority to resolve a default crisis unless they were granted special concessions, such as tax cuts they claimed would ignite economic growth and largely pay for themselves, but which ended up losing large amounts of revenue and making budget crises more likely in the future.

The debt limit provision of the balanced budget amendment would have one other effect as well. It would open up a large loophole in the federal budget process that was closed in 1990 with passage of the Credit Reform Act. It would effectively repeal the central reform of that act and allow widespread use of loan guarantees as a gimmick Congress could use to evade the balanced budget rules and shift more of the budget balancing burden to future Congresses. These issues are discussed below.

The exact levels of government expenditure and government revenue for a given year depend to a significant degree on the state of the economy. They cannot be predicted in advance with precision.

When the economy grows more quickly than forecast, expenditures are lower and revenues higher than predicted. When the economy grows more slowly than forecast, the reverse occurs; this happens even when the growth rate differs from the forecast by only a fraction of a percentage point. In addition, the performance of the stock and bond markets and the decisions that investors make concerning when to sell securities have significant effects on government revenue levels in ways that cannot reliably be predicted in advance.

In some fiscal years, either expenditures have been higher or revenues lower than forecast, and the deficit has been significantly greater than the Congressional Budget Office and the Office of Management and Budget predicted at the start of the fiscal year. In other years such as fiscal year 1996, the opposite has occurred, and the deficit has been significantly lower than was predicted when the year began.

If the balanced budget amendment is part of the U.S. Constitution, it is inevitable that there will be numerous occasions where CBO concluded at the start of the year that Congress and the President had balanced the budget, but it became clear as the year unfolded that a deficit would occur. As noted above, even modestly slower-than-expected economic growth could have such an effect. So could a costly natural disaster as well as decisions by investors regarding when to sell assets.

If a significant deficit threatened to develop during a fiscal year, the balanced budget amendment could pose unpalatable choices. Suppose the specter of a significant deficit emerged half-way through the fiscal year. To achieve savings in the few remaining months of the fiscal year sufficient to maintain budget balance might be impossible unless major programs or significant parts of the government were cut deeply or even closed in the final months of the year. It might well prove impossible to secure agreement to pass such severe legislation. But if it did not pass and three-fifths of Congress would not agree to raise the debt limit, default would loom.

In an August 1995 report, the Congressional Budget Office called the debt limit "an anachronism." CBO said that: "By the time the debt ceiling comes up for a vote, it is too late to balk at paying the government’s bills without occurring drastic consequences."²

This CBO conclusion reflected the fact that until now, the debt limit has always been raised when the nation approached it. Even so, raising the debt limit has been no easy task. Securing the votes of a simple majority of those present and voting to raise the debt limit often has been excruciating. By raising the bar and requiring the approval of three-fifths of the full membership of both chambers to raise the debt limit, the constitutional amendment would make it extraordinarily difficult — and perhaps impossible — to raise the debt limit on some occasions. Yet as CBO has noted, at the point when the debt limit is about to be breached, it usually is too late for other alternatives.

The authors of the balanced budget amendment argue that the specter of default will ensure Congress and the President reach agreement to balance the budget in the first place. They confidently predict that the threat of default will operate as a deterrent to prevent passage of an unbalanced budget. This argument, however, does not respond to the virtual certainty that in many years in which Congress and the President act in good faith to balance the budget, the budget will subsequently become unbalanced during the fiscal year for reasons beyond policymakers’ control. The balanced budget amendment makes it likely that on many of those occasions, such a development will precipitate a default crisis.

To illustrate the possible magnitude by which a budget that is initially in balance could move out of balance, consider the circumstance in which outlays turn out to be two percent above CBO’s estimate and revenues two percent below. In such a circumstance, a budget initially thought to be balanced would develop a deficit of about $30 billion. If the $30 billion deficit was recognized part way into a fiscal year, it would be extremely difficult to address. (The ambitious balanced budget plan embodied in the budget resolution that the 104th Congress passed in the spring of 1996 would itself have achieved only $27 billion in savings in fiscal year 1997, with a full 12 months in which to realize the savings that year. Achieving $30 billion in savings when a significant part of the fiscal year has already passed is very difficult.)

Consider also what would occur if a normal-sized recession were to start three months into the fiscal year. What was thought to be a balanced budget could turn out to have a deficit of $40 billion. If a recession of the same size started three months before the fiscal year began and went unrecognized until the quarter was over, which is normally the case when a recession starts, what was thought to be a balanced budget could turn out to have a deficit in the $80-$100 billion range.

If a deficit loomed and it was not possible to amass the support of three-fifths of both chambers of Congress to increase the debt limit, the Treasury would run out of cash before it could pay all of its legally binding agreements, including agreements to pay interest on existing debt. As a result, the government would default — that is, it would renege on its debts.

The government has faced debt crises before. For example, in 1990, the nation was faced with huge across-the-board budget cuts because the fixed deficit targets in the Gramm-Rudman-Hollings Act proved unrealistic for reasons largely beyond policymakers’ control. When that occurred, Congress acted by a majority vote to raise the deficit targets to more realistic levels and to raise the debt limit. (Congress included major deficit-reduction measures in the same legislation.) Such action to raise the debt limit, however, would now require a supermajority vote.

More recently, in the fall of 1995, even a simple majority vote could not be secured for several months to raise the debt limit and end a budget crisis. On this occasion, the Treasury Department was able to use a series of mechanisms to avoid a default. But the balanced budget amendment would outlaw most of those mechanisms.

The debt limit that the balanced budget amendment would impose (and allow to be raised only by a three-fifths vote of both houses) is a limit on "debt held by the public." This differs significantly from the measure of debt used as the statutory debt limit until now. The current legal limit applies to "gross federal debt," which includes both debt held by the public and the amounts the Treasury has borrowed from federal trust funds and owes to them. This change that the balanced budget amendment makes in the definition of the debt limit is highly significant. During past debt crises, the Treasury could "un-borrow" from these federal trust funds without doing any harm. The Treasury would revoke some of the Treasury securities held by such trust funds as the civil service retirement fund. That would get the Treasury below the statutory debt limit and allow it to use the extra room to borrow cash so it could pay immediate bills. Treasury securities would be reissued to the trust funds when Congress eventually raised the limit.

This was the principal mechanism the Treasury used to avoid defaulting during the fiscal crisis of late 1995. But since the balanced budget amendment imposes a limit on debt held by the public and ignores debts owed to the trust funds, the Treasury would no longer be able to use this mechanism. The Treasury would no longer have any significant maneuvering room if it reached the debt limit and Congress and the President could not quickly find a way out of the budget impasse.

For these reasons, the amendment materially increases the likelihood of default. If default occurred, the consequences would be serious. The Congressional Budget Office warned in 1995:

Business Week sounded a similar note, calling default "an unimaginable act of weakness."4

The Amendment Could Precipitate Default Crises
Even When the Budget is Balanced

The debt limit provisions of the constitutional amendment fail to take into account the fact that the Treasury needs to borrow even when the budget for a fiscal year is balanced. In a year when the budget is in balance, the government will operate in the red for the first six months, in the black by a substantial amount in April when a large volume of income tax payments are recorded, and in the red in succeeding months except September (when many estimated tax payments are received). This necessitates Treasury borrowing during the first six months of the fiscal year even when the annual budget is in balance. If the debt limit were set at a level that allowed no increase in borrowing, the government could face a default during months in which it needed to borrow even though the budget for the year was balanced.

Suppose that an economic slowdown, a damaging and costly earthquake, or some other event were to throw the budget out of balance by $100 billion or more. Trying to eliminate a projected deficit of that size in the remaining months of a single fiscal year would remove so much purchasing power from the economy in such a short period that it could trigger or exacerbate a recession. It also could necessitate the shutdown of part of the government for the months remaining in the year in order to shrink government expenditures enough to restore budget balance. Raising the debt limit and permitting a deficit would represent the only practical course.

But while a debt limit increase would be the only rational course, any Congressional faction with 40 percent plus one of the votes in the House or the Senate could block it — and make the threat of default extremely serious — unless it was granted major policy concessions as the price for its votes to raise the debt limit. With the unthinkable consequences of default looming, stubborn Congressional factions would have great leverage to extort policy changes they sought.

Those in Congress most willing to threaten the functioning of the federal government tend also to be those who support the largest and most regressive tax cuts, which frequently are defended on scant evidence as being the medicine needed to spur high rates of economic growth. A congressional faction would be well-positioned to extort large tax cuts that would cause the government to lose substantial amounts of revenue in the future — and thus to make future budget crises more frequent and more serious — as the price for its votes to raise the debt limit and save the nation from immediate default.

The amendment’s authors themselves acknowledge this threat of extortion. In a paper on the balanced budget amendment they circulated in November 1996, Reps. Dan Schaefer and Charles Stenholm wrote:

Stenholm and Schaeffer go on to acknowledge that their amendment would have the effect of "lowering the ‘blackmail threshold’...from 50% plus one in either body to 40% plus one..." They essentially admit their amendment would make extortion easier.

They nevertheless defend this aspect of their amendment, arguing that by lowering the extortion threshold, their amendment "increases the motivation of the Administration and the leadership, including the Chairs of the relevant committees, to do whatever is necessary, legislatively and cooperatively, even to the point of balancing the budget, to avoid facing such a difficult debt vote." This misses the basic point that even when Congress and the President agree on a honestly balanced budget, a deficit of tens of billions of dollars — or even $100 billion or more — can materialize within a short time due to factors beyond their control. When that occurs, the government will face a choice between raising the debt limit or defaulting, and the constitutional amendment will confer great powers of extortion on a minority in either chamber.

1. Reps. Dan Schaefer and Charles Stenholm, materials entitled "Cosponsor the Balanced Budget Amendment," November 18, 1996.