That Bad Treasury Bond is Turning Up Again

***An abbreviated version of this blog post appeared in The Hill’s Congress Blog on April 4. This version takes a deeper dive than is possible with 750 words.***

The temporary “suspension” of the nation’s debt limit expires on May 19, 2013.  On that date, the limit will become the amount of debt already incurred (see here).  The Treasury is prohibited from “borrowing ahead” to build up a cash balance, which makes the determination of the precise amount of the limit as of that date quite complex.

But the concept is clear enough.  On May 19, the debt limit will be (approximately) what the debt actually is as of that moment.  So the Secretary of the Treasury will need immediately to revert to the use of his “extraordinary measures” – highly technical authorities granted to him by law or custom, which over the last two decades or so have become unfortunately all too ordinary – to keep the debt subject to limit below the statutory ceiling.  As always, the public is not privy to the Treasury’s own internal estimates, and the future is always uncertain; but the best analysis available suggests that the Secretary will have run out of tricks by some time in this coming August.

Therefore, with the temporary tax cut expirations resolved, with appropriations for the federal agencies finally completed for the ongoing fiscal year, and the next fiscal year not beginning until September 30, 2013 (and with that appropriations process sure to be procrastinated down to the wire), it is likely that a collision with the debt limit will be the next budget-process bottleneck that the Congress and the White House will have to traverse.

Institutional memories are short in Washington, and history often is revised before it is written.  Somehow, a decent interval after the fact, 100 percent of the players on both sides of each Washington contest believe that they won the game.  So it is likely that the lessons of August, 2011 – and of the last several debt-limit standoffs – have not been learned as they should.  Thus, it is worth taking the opportunity of the waning days of the Easter/Passover congressional break to review just why going to the brink over the nation’s debt limit is such a bad idea.

This should not be a partisan issue.  The points below would apply regardless of who is in control of the White House, the Senate, or the House of Representatives.  Today’s situation is unique in detail, as is every day in Washington; but the amount of the stakes on this issue is always the same: approximately everything we’ve got.  So both current and future Congresses and Administrations should consider the following:

A fight over the debt limit is prone to disaster.  Even though the stakes on the debt limit are monumental, Members of Congress will always be inclined to grasp any opportunity to extract concessions from a President with different views.  Still, over time, standards of behavior on this front have deteriorated.  As they push a President further and further toward the brink, Members today should consider the precedent they risk setting.

Every President becomes aware early in his term that he acts on behalf of all of his successors.  No President wants to be the first to make concessions with a virtual gun to his or her head.  Once that door is opened, other adversaries – not necessarily from the United States, and with demands not necessarily about the budget – will surely try to pass through as well.  Members of Congress from the opposite party should consider how they would regard a similarly situated President from their own party should he or she buckle under partisan pressure, and then gauge the consequences of brinkmanship to push a President into submission.

There is playing political hardball, and then there is playing political chicken.  Decision-makers must know the difference.  No Member of Congress wants to vote to increase the debt limit.  The public at large does not understand that increasing the debt limit merely allows the Treasury to pay individuals and businesses who already have fully legal and valid claims, and that it does not authorize further spending not already sanctioned by law.  Few people understand that if the federal government had to cut its outlays immediately by tens or hundreds of billions of dollars, the economic consequences could be catastrophic.  To the rank-and-file voter, increasing the debt limit is tantamount to approving fiscal irresponsibility.  As a result, it is common for Members of Congress from the political party not in the White House to sit on their hands on a debt limit vote, and to wait for the Members from the other party to put their votes on the board so that their party’s President can borrow the cash he needs.  That is one thing.  Threatening economic catastrophe by preventing a debt-limit increase to extract a political price is quite something else.

The U.S. economy is weak, and its resilience is uncertain.  Many economic forecasters see the risk to the U.S. economy primarily on the downside.  And for that matter, virtually every major economy around the world is shaky, primarily from the aftermath of the global financial crisis; and the world relies on the United States, the economic superpower, as its flywheel to maintain forward momentum in unstable times.   Such widespread weakness is inherently dangerous.  If the U.S. economy itself becomes destabilized, we could join the rest of the world in what easily could become a mutually reinforcing downward spiral.

Don’t hit a sector when it’s down.  The parts of the economy that would be most directly affected by a renewed debt-limit crisis are precisely those that remain most weakened by the 2008 financial crisis.  The financial markets themselves are just beginning to rebuild confidence and to provide intermediation for investment and economic growth.  Some U.S. state and local governments have begun to recover financially, but they remain vulnerable; others governments are still quite weak.  Because of these still partially open wounds, the effect of another debt-limit pounding would potentially be greater.

And by the way, Social Security is not immune to a debt crisis even though it has its own trust fund with “special certificates.”  To redeem those assets for cash, the Treasury Department must sell new marketable securities to the public; and because Social Security’s tax revenues are no longer sufficient to cover its benefit payments, the Treasury must borrow even more than in the past to fill the gap.  Social Security’s trust-fund assets absolutely are backed by the full faith and credit of the United States of America.  The question is:  What is the full faith and credit of the United States of America worth?

Market reactions to a U.S. debt-limit crisis would be inherently unpredictable – but surely all bad.  Admittedly, we don’t know precisely how investors or other nations would react to another debt-ceiling standoff between the White House and the Congress, because our experience is thin.  And apart from one brief faux pas more than 30 years ago – part of a squabble over the debt limit, but nothing like the debt war of 2011 – we have never actually gone over the brink.  But you cannot tell a happy story from the family of possible outcomes of a standoff this year.

A downgrade.  Probably the most commonly mentioned potential fallout would be a downgrade of U.S. Treasury securities by the various ratings houses.  And we do know that one ratings house downgraded Treasury securities in the last episode, and that in the event of a replay, the others likely would follow, and possibly even go further.  Multiple downgrades rather than by just one ratings agency, and downgrades by more than one notch, could be devastating.

Some surely will pooh-pooh the economic and financial consequences of a downgrade resulting from a debt-limit war in Washington.  The United States remains “the best-looking horse in the glue factory,” and some will suggest that financial uncertainty would set off a “flight to quality” in the financial markets – which means, paradoxically, to U.S. Treasury securities.  But just realize that a flight to quality means a flight from somewhere else – and that “somewhere else” is the U.S. private-sector securities that today undergird our economic recovery, such as it is.  Weakening the economy today would reduce government revenues and increase government outlays, and thereby not only cause enormous pain among households and businesses, but also swell the budget deficits and the public debt, and leave us primed for a worse debt crisis tomorrow.

We also know that the ratings of financial institutions and other entities that must maintain rock-solid security would suffer if their key holdings – in U.S. government bills, notes and bonds – were to be downgraded.  If you want to think of the impact of a widespread Treasury downgrade on the nation’s financial infrastructure, imagine the effect of a bacterium that would make concrete crumble on the nation’s physical infrastructure.

The ill effects of a downgrade could take another channel, and go even further.  Some fiduciary institutions are governed by covenants that require that they hold some minimum level of only the highest-rated securities.  A Treasury downgrade could compel those institutions to sell at least some of their holdings – all at once.  Exactly how widespread and how iron-clad such covenants are, no one really knows.  But we should not risk finding out for sure.

Effect on the budget.  Virtually every financial expert would say that a debt-limit standoff would increase interest rates on Treasury securities, possibly for a long time.  Borrowers survive on trust.  Once trust is broken, it can be hard to rebuild.

Some prefer to define the term “default” narrowly, and say that only an actual failure to redeem Treasury securities in a timely fashion, or to make an interest payment on time, should fulfill that term.  They sometimes go further and say that the Treasury should “prioritize” its payments, so that it can pay interest and redeem bonds on time, at the expense of other, “lower” priorities.  As of now, the Treasury has no payment system capable of such prioritization; and presumably Congresses and Presidents defined all of the existing priorities as at least high enough to spend the money in the first place.  But still, proposals to prioritize continue.

Again, because the payment record of the United States of America has until recently been beyond question, we have no concrete track record from which to judge prioritization.  But would we expect a prospective mortgage lender to be reassured if a consumer said, “Oh, don’t worry, I’ve made my mortgage payments; it’s just the car loan and the electricity, water, and telephone bills that are behind?”  Would we expect a foreign government, or an insurance company or a pension fund that could have immediate need for its money, to accept such a spotty credit report from the United States Treasury?

Prospective lenders who see risk demand higher interest rates to compensate.  Numerous financial houses and think tanks have rendered estimates of the cost of a debt standoff in terms of higher future interest payments.  Perhaps the most widely cited estimate is that of the Government Accountability Office.  GAO concluded that the failure of the federal government to increase its debt limit in a timely fashion in 2011 increased the Treasury’s debt service costs by $1.3 billion in that year alone.  Those costs are expected to be repeated and to grow in future years.

To the extent that such dislocation in the Treasury market is passed through to the interest rates on private-sector loans, or otherwise disrupts the economy, tax revenues will decline and federal government outlays will increase – thereby increasing the public debt which must be serviced at those increased interest rates.  Financial irresponsibility could accelerate every segment of a vicious cycle of budget and economic decline.

Yes, interest rates are very low right now, precisely because the economy and credit demand are weak.  But a loss of trust in the markets will exact a price after the economy finally climbs off the mat – which we all hope it will, sooner rather than later.

Our nation’s place in the world.  The rest of the world also is relevant, in two respects.  Over the last dozen years, roughly two of every three net new dollars of Treasury borrowing from the public have come from overseas.  And about two out of three of those foreign dollars come from governments rather than private investors.  Foreign investors – and foreign governments in particular – may behave very differently from private U.S. investors, who follow a very simple calculus of risk versus reward in their own currency.  Foreign investors and governments may some day become much less blasé about the political jousting in Washington that Americans might take for granted.

Furthermore, flirting with default cannot raise our nation’s prestige.  Top U.S. government officials of both parties long have reported that the tone of their receptions in foreign capitals has been determined to a considerable degree by the state of our nation’s finances.  In times of global tension, there could be more than small talk and dinner toasts at risk.  Why should we be willing to downgrade the flag as well as our credit rating?

Again, praise be, we do not have deep experience with a U.S. Treasury on the brink of default, and so we cannot predict a potential outcome with certainty.  But running such a risk would be like a sole family breadwinner demanding proof of an imminent demise before investing in life insurance.  Why in Hades would our elected leaders put the future of our children and grandchildren on the craps table in such a fashion?

If the Congress wants to play hardball with the President over budget policy, it can threaten to shut down the government over the appropriations bills at the end of September.  That only makes the United States look like a keystone-cops operation that cannot manage its own affairs.  Going to the wall over the debt limit, by contrast, paints Uncle Sam as a deadbeat who cannot or will not pay his bills.  If that is the choice, let’s take the higher (I wouldn’t call it the “high”) road.

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