Monday, July 18, 2011

Some Thoughts on the Unthinkable

In his April 4 letter to Congress on the urgent need to raise the debt limit, the Secretary of the Treasury made the following claims:
As the leaders of both parties in both houses of Congress have recognized, increasing the limit is necessary to allow the United States to meet obligations that have been previously authorized and appropriated by Congress. Increasing the limit does not increase the obligations we have as a Nation; it simply permits the Treasury to fund those obligations that Congress has already established.

If Congress failed to increase the debt limit, a broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on the debt, unemployment benefits and tax refunds. This would cause severe hardship to American families and raise questions about our ability to defend our national security interests. In addition, defaulting on legal obligations of the United States would lead to sharply higher interest rates and borrowing costs, declining home values and reduced retirement savings for Americans. Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover.

For these reasons, default by the United States is unthinkable.
Unthinkable as it may be, it's worth giving this a little thought.

Strictly speaking, the Treasury could continue to make payments on all obligations authorized by Congress, simply by sending out checks as they come due. Commercial banks would undoubtedly accept these from depositors, confident in the knowledge that the Fed would create the reserves necessary to credit their accounts. If the Fed were concerned about the resulting expansion of the monetary base, it could neutralize this by selling bonds on the open market. The result would be an increase in the debt held by the public, with no change in the monetary base, which is exactly what would transpire if the deficit were financed by the issue of new bonds.

The problem, of course, is that the Treasury's account at the Fed would then be vastly overdrawn and the debt limit thereby exceeded. Instead of borrowing from bondholders, the Treasury would be borrowing, so to speak, from the Federal Reserve. I'm quite certain that in the current political climate this would be treated by Congress as a usurpation of its power, resulting in a constitutional crisis and possible impeachment. Not surprisingly, the Treasury Secretary is reluctant to go down this road.

The only alternative is for the Treasury to meet some of the obligations authorized by Congress while failing to meet others. For this to happen, someone in the executive branch would have to decide which prior appropriations made by Congress to respect, and which to ignore. Interest and principal on the debt would probably receive the highest priority, given constitutional imperatives. But everything beyond that, it seems, would be fair game. By respecting one law -- the debt ceiling -- the Treasury would be forced to disregard others. Payments to contractors, congressional and agency staff, state and local governments, social security recipients, and health care providers would all need to be prioritized. This is a bizarre and highly undemocratic manner of repealing legislation.

I doubt very much that it will come to this. If the Treasury were able to communicate its priorities credibly to the public, making clear exactly who would get paid and who would not, I suspect that we would have an agreement in short order. But even if we get past the current crisis unscathed, the same scenario is likely to be repeated whenever government is acrimoniously divided in the future. Accordingly, it's worth thinking about the kind of structural changes that could help us avoid a periodic repetition of this farce.

One possibility is to absorb an increase in the debt ceiling into any legislation that has budget implications, and to do so in a manner that allows for all the implied borrowing needs to be met. Any tax cuts or increases in appropriations should be accompanied by an authorization of borrowing so that all anticipated shortfalls in revenues relative to expenditures could be accommodated.

This would be very imperfect solution, because severe shortfalls in revenues relative to expenditures are often unanticipated. Unusual economic conditions (such as those we are currently navigating) can devastate revenues just as expenditures are rising sharply, thus pushing the deficit outside bounds that were forecast when the legislation was enacted.

The only sure way to eliminate the contradictions implicit in current laws would be to repeal the debt ceiling itself. This is what common sense would dictate. But expecting common sense to guide the legislative process in the present climate... now that is truly unthinkable.


  1. a 38pp debt limit analysis (PDF) from the bipartisan policy center:

    a post from libertarian blogger megan mcardle @ the atlantic, in which she is attempting to convince her right wing followers that stonewalling the debt ceiling vote is a non-starter:

  2. "Interest and principal on the debt would probably receive the highest priority, given constitutional imperatives."

    Why so? Because failing to meet these rather than other obligations would hurt the richest the most? And because the White House is almost as fully controlled by the richest as the Republicans?

  3. rjs, thanks for the links.

    Som, the constitutional imperatives I had in mind are contained in the 14th Amendment: “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.”

  4. Rajiv,

    In fact this statement from the 14th amendment does not prioritize principal and interest. The "debts" that must be paid include "pensions" and indeed legally any payment authorized by the Congress and signed onto by the president is a "debt." Indeed, you are right that illegality is unavoidable. It is just as illegal for the Secretary of the Treasury to prioritize payments as it is to violate the debt ceiling. And caving means this will happen again, even though no other nation in world history has had a nominal debt ceiling of this sort (although the US's has been around since 1917). So, if there is no agreement, and he should not agree to anything too drastic, he should declare it unconstitutional and ignore it. Let them impeach him, a big nuisance, but he will win on that in the end, and he will save the world economy.

  5. Barkley, I'm no constitutional scholar but it seems to me that the amendment refers to debts incurred for payment of pensions and bounties in the past, and not to any promises, implicit or explicit in laws, to make payments to individuals in the future. Nonpayment of interest and principal would be unconstitutional, while nonpayment of social security would be illegal. That's how I read it in any case.

    I am not in favor of ignoring the debt ceiling, but if this is done then I would prefer the option described in my post (running up an overdraft at the Fed) rather than issuing new bonds. Otherwise yields could spike, possibly resulting in panic and chaos.

  6. I did not know everytime they exceed the budget they have to go for congress authorization for increase in debt which I presume is throuh issue of govt. Bonds. But here in india they go in for supplemenatary estimates and the discretion whether to cover the deficit by borrowing from the Central Bank or by isssue of Bonds is left to the executive.
    Increasing debt increas money supply through higer expenditure for which the debt is incurred but it also withdraws money from the market if subscibed by not only by banks but public.

  7. rjs, thanks again for the link to Megan McArdle's article, it's very good. Especially this:

    "If we had to cut spending--if no one would lend us any more money--could we do it? Definitionally, yes. But it would mean an enormous amount of real suffering: homeless families, hungry old people, nursing homes closing their doors to indigent patients. And the fact that we could do it if we had to doesn't mean that we can therefore do it when we don't have to. If you try to artificially create a situation that requires drastic cuts, voters are going to get rid of you, not the spending."