Today, at 6:30PM, the US Congress is due to vote on vote on a bill that would raise the nation's $14.3 trillion debt limit to $16.3 trillion without any accompanying spending cuts. The idea that mandatory debt ceilings inscribed in special legislation or even in the Constitution is again the focus of strong controversy in both the USA and Europe. However, many people oppose or support the ceilings on the basis of two apparently reasonable ideas.
For the opposing camp they are useless because they will be broken whenever politically expedient horse-trading takes place. The supporters defend them on the grounds that they force the politicians to compromise and thus reduce their impetus toward spending. However, both are misguided because they fail recognize what is the rationale behind mandatory limits.
When mandatory limits are imposed by creditors, its rationale is clear - to reduce the risk for existing creditors. However, when the limits are self-imposed the logic must be based on some idea of what is the optimal level of leverage. Here comes the problem – what is the optimal level?
To find the optimum leverage is extremely difficult in the case of private companies, and almost impossible in the case of governments. Fifteen years ago I worked on a corporate model for such purpose based on the common practice of using the debt coverage ratios demanded by bankers. However, because such optimum is constrained by the availability of collateral and the supply of leverage it means that in practice it is defined in relation to two volatile factors – the availability of investment opportunities with sufficiently good returns and loanable funds.
The recent credit crisis has shown again that when markets deviate from generally accepted trends the uncertainty caused by fear or euphoria will inevitably shift substantially any leverage levels previously defined as optimal.
For this reason in corporate finance we now prefer to use the concept of maximum debt capacity, calculated on the basis of the present value of projected free cash flows. Unfortunately, this is not easily applied to public finances because its accounting standards does not allow the calculation of the free cash flow and for the reason that the return on public spending is difficult to measure let alone forecast.
In the absence of a scientifically defined debt ceiling for normal circumstances (excluding war and massive natural disasters) it is wiser to rely on common sense and some prudence. So, if a ceiling is to be defined it should not be inscribed in the Constitution but on a special law approved by a qualified majority. The ceiling itself must be defined well below a conservatively defined level of leverage supply under normal circumstances using as a benchmark the corporate sector.
Otherwise, do not waste time fighting over arbitrarily defined ceiling limits, instead of the underlying policies.