What About the Debt Ceiling?
There’s been lots of talk recently about the debt ceiling, whether it will be raised again or whether Congress, in its infinite wisdom, will make the US government start passing bad checks. We’ve been dealing with this for years. The Treasury department projects when it’s debt limit will be reached, advises Congress, and asks that the cap on debt issuance be raised. Seemingly by default Congress then proceeds to wait until the last minute to do anything while raising the political temperature and creating anxiety for global markets. But then they end up raising the debt limit anyway as they have nearly 100 times in the little over 100 years since the debt ceiling was put into place.
Congress continues to raise the US’s borrowing limit because the limit is arbitrary. My understanding is that Congress created the limit back in 1917 as part of giving the Treasury more leeway when issuing bonds; more authority to borrow but with constraints. That was long ago and much has changed. In fact, lots of academics, economists, and others suggest that the debt ceiling concept is based on an antiquated view of how the global financial system works and is no longer necessary. These folks remind us that our government, for better or worse, has the only true blank check out there and can borrow so long as its creditors (you, me, and the rest of the world) are willing to lend. And at last check there was no shortage of people, even other governments, lining up to buy our debt. Final judgement on the rightness of all this is beyond me, but I’m likely not the only one who thinks it’s a little silly and frustrating to go 15 rounds on the debt ceiling time and again only to raise it anyway.
So is it different this time? So-called extraordinary measures to keep government payments flowing are expected to be exhausted by this summer. Will hardliners on both sides of the political spectrum finally get their wish of breaking up the financial system so they can rebuild it into (presumably) something better? Or will this be yet another foray into a political game of faux chicken where the result is known but we have to go through the drama anyway? Unfortunately it’s probably the latter. To be clear, an actual technical default by the US is highly unlikely but the continued high level of partisanship and acrimony in Congress means we have to at least consider the possibility.
In this vein I wanted to share some recent work by my research partners at Bespoke Investment Group. Bespoke addresses some of the practical market implications should the US actually be allowed to default. In short, none of it’s good but it may not be as bad as some predict.
From Bespoke but edited for brevity…
Unlike all other developed countries, the United States operates under a statutory debt cap. After Congress authorizes spending, Treasury cannot issue debt in order to make payments that Congress has instructed it to make via the appropriations process. Instead, the Treasury can only issue debt up to a dollar cap (currently slightly more than $38.3 trillion). The dollar cap is entirely arbitrary and independent of the spending authorized by Congress, which can create situations whereby Congress gives conflicting instructions to the Treasury. In addition to raising the dollar amount of the debt cap, Congress occasionally elects to temporarily suspend the debt ceiling. The debt ceiling is not an explicit constitutional requirement but entirely a product of legislation.
Once the debt limit has been hit (as is currently the case), Treasury has some operational flexibility to change the timing of payments and source of transaction funding to keep payments functioning. As of this writing (2/7/23), we are currently in that mode. The primary “extraordinary measure” involves spending down cash balances in the Treasury General Account (TGA). The TGA is a transaction account at the Federal Reserve that is an asset of the federal government and a liability of the Federal Reserve…
Once extraordinary measures are exhausted, what is left for the Treasury to do? There are three broad categories of choices it can make about how to continue managing payments.
- The Treasury could undertake prioritization, making some payments but not others.
- A general default would mean no payments made by the Treasury…
- There are a series of technical work-arounds that might allow the Treasury to continue issuing debt.
- By far most dramatic solution would be for the executive branch to ignore Congress and unilaterally declare the debt ceiling unconstitutional.
There are two major technical work-arounds that might allow the Treasury to continue making payments after hitting the debt ceiling.
- The Treasury could issue a platinum coin for deposit in the TGA. This solution has been discussed by other outlets for years… The idea is that US statute permits Treasury to issue platinum coins in arbitrary denominations. Those coins are not subject to the debt ceiling and could therefore allow spending to continue without more debt issuance. It’s not clear whether this plan would pass legal muster…
- The Treasury could issue very high coupon bonds. For instance, a bond that was otherwise the same as the current 30 year Treasury bond but paying a 100% rather than 4% coupon would trade at a price greater than $1800 per $100 of principal, allowing the Treasury to reap huge amounts of new borrowing with no change to outstanding principal debt. Obviously a 100% coupon bond is an ad absurdum example of this concept, but it serves to illustrate how the basic approach of high premium bond issuance would work. We aren’t lawyers but doubt this program would face significant legal pushback.
The final option for Treasury to declare the debt ceiling unconstitutional under Section IV of the 14th Amendment of the US Constitution. That language follows:
The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.
While the rest of the 14th Amendment has been litigated in exhaustive detail, this section has only been briefly discussed by courts.
But under a maximalist reading, “the validity of the public debt...shall not be questioned” seems to create a clear constitutional obligation to pay existing debt.
Again taking a maximalist reading, “debt” is previously committed-to (appropriated) spending as well as coupon or principal payments on bonds. Under that thesis, any debt limit would be unconstitutional, because it bars Treasury from conducting its Constitutionally-mandated job of ensuring the “validity” of public debt.
Now, this is obviously an aggressive interpretation of the 14th Amendment. But it’s plausible that the Biden Administration (or any other Administration in the future), if faced with a choice between general default with financial market chaos and an aggressive legal argument, would elect to continue issuing debt under the auspices of the 14th Amendment. At that point, the federal courts would have to step in. How that would go is anyone’s guess, but if the consequences of a decision declaring the debt ceiling constitutional were a general default, it’s hard to envision that the courts would willingly play the bad guy and force a Treasury default.
Partisan politics created and have reinforced the debt ceiling as a bargaining chip over time, despite its redundancy and absurdity. Responses to the debt ceiling are inherently political as well. Prioritization of payments means political actors picking winners and losers who have equal claims. How are decisions like choosing between bondholders or social security beneficiaries as to who gets paid on time to be made? On the other hand, an effort to invalidate the debt ceiling on constitutional grounds would create a political fight in the courts. The political questions are nearly never-ending, but there are also practical considerations. In a general default or any outcome where payments of coupon or principal for Treasuries are missed, expect significant selling pressure for impacted securities: bills maturing during the period in question as well as notes and bonds with coupon payments due during the period. The secondary impact of these missed payments would undoubtedly lead to selling of other securities as well…
The list of possible what-ifs in a default is endless, but at the margin, any actions or events that make the prospects for timely payment less likely, diminishes some of the safety imbedded in US Treasuries. When S&P downgraded the long-term debt rating of the United States from AAA to AA+ in 2011, the debt ceiling debate was cited as a primary reason when the Chair of the firm’s sovereign ratings committee commented that “The first thing it could have done is raise the debt ceiling in a timely manner so the debate would have been avoided to begin with”.
The short-term relative value implications of a US default are perhaps less relevant than the longer-term implications of a US default. For domestic investors, even a full US default wouldn’t drive a major shift away from Treasuries… A US bank or insurance company would find it difficult to shift to another major currency’s government debt not just from a logistical perspective but because they would now be faced with foreign exchange risk.
For overseas investors, foreign exchange risk is already being taken, so the considerations are different. To be sure, foreign investors are still a large part of the US Treasury market, holding more than 20% of Treasury’s public debt outstanding and more than 30% of marketable Treasury debt.
While still a large share, keep in mind that foreign investors are a steadily declining share of Treasury debt. From the 1980s through the mid-2000s, foreign held share of marketable Treasury debt more than doubled from less than 20% to more than 56%. But despite very large federal deficits and a rising debt-to-GDP ratio over the course of the global financial crisis and COVID pandemic, foreign Treasury holdings are down to 30.9% of marketable Treasury debt. Domestic owners of the US Debt are, therefore, far more important, and while a foreign owners’ strike on buying Treasury debt would be extraordinarily disruptive, it may be manageable.
If foreign buyers did decide to drop Treasuries, what would they buy instead? No other high quality asset market is close to the size required to absorb $7.3trn in foreign Treasury holders’ assets. The costs of realized prices during the volatile post-default period, liquidity challenges in alternative markets, and their higher volatility relative to Treasuries may lead a huge swath of Treasury investors to shrug and swallow missed payments instead of dealing with the headache of reworking their entire portfolio at once. In other words, it wouldn’t be surprising to see little change in the global benchmark role for Treasuries even in the event of a US default over the debt ceiling.
Here's Bespoke’s website if you’re interested.
Have questions? Ask us. We can help.
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