The debt ceiling and scaremanship
By Daniel M. Ryan
Prior to now, raising the debt ceiling – the total amount the United States Treasury can legally owe - has been little more than a formality. Political observers took raises so much for granted, cynics had a grand old time saying that the real debt ceiling is infinity.
Not any more. Like it or not, the United States system still requires Congressional authorization to raise the total amount by which the U.S. Treasury can legally be indebted. That's why requests to raise the ceiling are requests, not orders. They can't even be described, except by cynics, as disguised orders. There's no such thing as squatters' rights in constitutional law. John Boehner and the rest of the Republican caucus are perfectly within their rights to withhold approval. They're also within their rights to link approval to spending cuts.
Of course, this conditional withholding is being decried as "brinksmanship" – which only could be the case if Treasury officials acted as if they took approvals for granted. If that's the truth, then there's a case on separation-of-powers grounds for the House to get a little ornery.
As the Treasury's actual borrowings grow to meet the $14.3 trillion debt ceiling, Speaker Boehner's stiffened spine is being met with outcries. One of his critics is none other than the Chairman of the Board of Governors of the Federal Reserve System, Ben Bernanke. Chairman Bernanke raised the spectre of another failure like Lehman Brothers should the debt ceiling not be raised pronto when testifying to the Senate Banking Committee. I'm sure he was acting out of public-spirited motives, but his remark strikes me as scaremanship.
What The Debt Ceiling Isn't
It's often claimed that freezing the debt ceiling will mean the U.S. Treasury won't be able to spend anymore. That claim is simply wrong. The debt ceiling does not take away the U.S. Treasury's power to spend: Treasury can dole out all the tax revenue it receives. It's just barred from spending more than its tax receipts.
Another, more plausible, claim is that the debt ceiling prevents the Treasury from borrowing. There's a lot of truth to this, but there's an important exception: Treasury can still roll over its existing debt. It can borrow enough to pay off any debt that matures, because maturing debt shrinks the total debt outstanding. If $5 billion in T-bills come due when Treasury debt is exactly at the debt ceiling, the maturing of those securities knocks down the debt outstanding by $5 billion. One those bills mature, the Treasury can borrow $5 billion more.
It can do so on the same day – even at the same minute. Financial transactions typically settle at the end of the day. So, it would only be bending the debt ceiling mandate for the Treasury to issue new debt a few minutes before the maturing debt is redeemed. Doing so is a clear case of no harm, no foul. The legality of same-day but beforehand issuance is ambiguous enough to require the Supreme Court to render a decision. Should the Court take a strict-constructionist stand, there's still a workaround. The Federal Reserve could set up a limited liability company called – to invoke a certain precedent – Treasury Lane. Treasury Lane's reason for being would be to hold any new issuance of Treasury securities that replace maturing issues. The Fed need only capitalize it at 10%, and Treasury Lane could borrow the other 90%. The instant the U.S. Treasury sends out payment for an issue that matures, Treasury Lane would step in and buy the entire tranche of the replacement issue. If programmed properly, this rollover could take place in milliseconds.
Even if a Treasury Lane doesn't move in with the Maidens, the Treasury market is so liquid that a quick sale of the full rollover issue is all-but guaranteed. All that needs to be done, to make a sale absolutely guaranteed, is to add several basis points to the rate after setting it in the normal way. The notion that the Treasury would have to cut off all and sundry on the day a bill, note or bond issue matures is just a myth.
I believe that Chairman Bernanke, in sounding the alarum, really wasn't trying to be an alarmist. The fellow's taken a lot of flak for being too blasé about the pop of the housing bubble and its engenderment of the `08 Crisis. In the spirit of disclosure, I have to admit to whistling past the graveyard myself in early `08.
His warning cry could have been showing wakefulness at the switch – showing that he's learned his lesson. He can be commended for changing his ways, but I think he picked the wrong way to do so.
As noted above, the Treasury debt market is very liquid; there's a lot of demand for those securities. Bumping against the debt ceiling and being restrained from issuing more net debt would decrease the flow of supply to the market. If the demand rate remains unchanged and the supply rate is crimped, the price is going to go up: that's basic economics. Should the Treasury be barred from issuing more debt, ceteris paribus, rates should go down – not up. Because the U.S. Treasury would be barred from bloating its debt load beyond the debt ceiling, assuming ceteris paribus, credit default swap premiums should shrink.
There's only one reason why rates would go up and credit-default premiums jump: fear that the Treasury would default. Any such fear is groundless. As explained above, the Treasury can roll over any maturing debt so as to have the cash to pay off any maturing issues. A default would mean not having to issue the funds to pay off any maturing issues, but it would also mean that the Treasury couldn't borrow any more except at ruinous rates. In the immediate term, a default is no more than a wash: the maturing securities would be rolled over anyway. To be more explicit, the Treasury has nothing to gain from a default in the immediate run. If they have nothing to gain, why would they?
It's true that there would be a net gain for the Treasury over the short term if it defaulted, as it would no longer have to pay any interest on its extant debt, but the longer-term consequences are obviously baleful. Even if the debt ceiling were raised later, the Treasury might not be able to borrow at all. If it could, the rate would be ruinous – high enough to make the interest take a predominant chunk of its inflow.
Given this basic cost-benefit analysis, there's only one reason why the Treasury would default: because Treasury officials want to default. Clearly, they have the option not to do so. The notion that they would default out of spite, ruin the good credit of the Government of the United States of America to get back at the House Republicans, is ludicrous.
It is true that the U.S. government would have to tighten its belt hard. But, as I explained above, the same would be the case if the Treasury defaulted. Only the interest payments would be saved, as defaulting prevents rollovers except at ruinous rates. A default would make for a de facto debt ceiling that could not be raised by Congressional action. There's just too little to gain from a default for it to be even a thinkable – in contradistinction to a fantastical – possibility.
The U.S. government being put on a crash diet would impact GDP, for the same reason that maxing out the credit card means no more free-spending ways. The impact on GDP might be enough to induce temporary negative growth, perhaps even a double-dip recession. Had Chairman Bernanke warned about this downside, he would have been on solid ground.
But a Lehman crisis? There's no way that the U.S. Treasury would face the fate of the Grecian government should the debt ceiling not be raised. Under ordinary circumstances, Treasury security rates would fall as a result of restricted net supply. There's no rational reason to expect the Treasury to default: there's absolutely nothing to gain in the immediate term, not much to gain in the short term and an awful lot to lose in the longer term. The notion that the Treasury would choose to default even stretches the limits of ordinary irrationality. Are professional fixed-income investors really that prone to going nutty?
Ben Bernanke can be given credit for turning over a new leaf and abandoning his previous blaséness. With respect to his testimony, though, he didn't pick his spot very well. He could have emphasized the danger to the recovery and his warning would have been plausible. Sad to say, Chairman Bernanke fell into scaremanship.