Must-Read: Bruce Bartlett On The Debt Limit
Capital Gains and Games alum Bruce Bartlett last week wrote a piece in Tax Notes on the debt ceiling that absolutely is must-read. I'm posting it here in its entirety with Bruce's permission and my strong recommendation that you take a few minutes to read it.
The Dangers of Debt Limit Brinksmanship
In a few weeks, the debt limit will be breached as all of the Treasury’s “extraordinary” measures are exhausted and there will be insufficient cash to pay all of the government’s expenses as they come due. These include payments of principal and interest on the debt. Therefore, default on the debt is almost inevitable unless the debt limit is raised in a timely manner.
While the debt limit and potential debt default don’t impact on tax policy directly, they are important indirectly. If the U.S. Treasury’s ability to borrow is inhibited by a default, that would cause investors to shun Treasury securities and raise interest rates, this will put increased pressure on the budget to raise revenue. That is why Alexander Hamilton discussed the consequences of default in Federalist 30, which relates to the federal government’s taxing power. Said Hamilton:
In the modern system of war, nations the most wealthy are obliged to have recourse to large loans. A country so little opulent as ours must feel this necessity in a much stronger degree. But who would lend to a government that prefaced its overtures for borrowing by an act which demonstrated that no reliance could be placed on the steadiness of its measures for paying? The loans it might be able to procure would be as limited in their extent as burdensome in their conditions. They would be made upon the same principles that usurers commonly lend to bankrupt and fraudulent debtors, with a sparing hand and at enormous premiums.
Especially at a time of war, any threat to the Treasury’s financing is a threat to national security. And, lest we forget, the nation is still at war in Afghanistan. Additionally, the recent Syria incident shows that the threat of new hostilities is ever-present. Nor should it be forgotten that 47 percent of the debt held by the public is now owned by foreigners. One can assume that they will not take kindly to any interruption in their interest or principal payments.
The threat of debt default and its impact on national security was very much on the minds of those who drafted the Fourteenth Amendment to the Constitution. The historian Franklin Noll has explained how representatives of the former Confederate states, now back in Congress, were highly disinclined to tax their constituents to pay the debts of the Civil War’s victors – the Confederate debt was repudiated, only the Union debt was repaid. Consequently, the threat of default was a very real one in the immediate postwar period.
To protect against the danger of default, the drafters of the Fourteenth Amendment included the little-known section 4, which reads:
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.
A number of legal scholars have concluded that this provision makes unconstitutional any law that would call into question or threaten the payment of interest or principal on the debt, including the debt limit. Only some of this work is in law reviews (Abramowicz 2011, Buchanan & Dorf 10-12, Buchanan & Dorf 12-12, Charles 2013). Most appears on legal web sites such as Balkanization, which is hosted by Yale law professor Jack Balkin; Dorf on Law, which is hosted by Cornell law professor Michael Dorf; and Verdict, a group blog.
In fact, there is almost no serious legal commentary explaining why section 4 of the Fourteenth Amendment doesn’t simply invalidate the debt limit. But that which exists has had inordinate influence; in particular, Harvard law professor Lawrence Tribe’s op-ed article in the New York Times on July 8, 2011. Among those apparently influenced by this article is Barack Obama, who studied under him at the Harvard Law School.
Government lawyers, not surprisingly, agree with whatever the president thinks. A few days after the Tribe article appeared, Obama was asked what he thought about using the Fourteenth Amendment in the event that Congress refused to raise the debt limit. At a town hall event, he said:
There is – there's a provision in our Constitution that speaks to making sure that the United States meets its obligations. And there have been some suggestions that a President could use that language to basically ignore this debt ceiling rule, which is a statutory rule. It’s not a constitutional rule. I have talked to my lawyers. They do not – they are not persuaded that that is a winning argument.
Former President Bill Clinton, however, has said publicly that he disagrees with Obama and that the Fourteenth Amendment gives him the constitutional authority to resist congressional extortion via the debt limit. In a July 11, 2011 interview with The National Memo, an online publication, Clinton said if he were in Obama’s shoes he would ignore the debt limit “without hesitation” to prevent a debt default and “force the courts to stop me.”
Not being a constitutional lawyer, I won’t weigh-in on the merits of the constitutional argument. But I think it is important to recognize that should Congress fail to raise the debt limit in a timely manner, President Obama will have no choice but to break the law; the only question will be which law to break.
This is a point that has been emphasized by law professors Neil Buchanan and Michael Dorf. They point out that the law does not permit the Treasury to prioritize payments or to decline to pay some so that others can be paid. Nor does the president have the legal authority to unilaterally raise taxes to pay debts that are due. Ignoring the debt limit would also be a violation of law, but Buchanan and Dorf argue that doing so is the least unconstitutional option.
On the other hand, Prof. Howell Jackson of the Harvard Law School argues that prioritizing payments is the least unconstitutional option. In a 1985 opinion, the U.S. Government Accountability Office supported this view. But it is worth noting that congressional Republicans apparently do not believe the president has inherent authority to prioritize payments and thus have voted for legislation to give him that authority. H.R. 807, the “Full Faith and Credit Act,” passed the House of Representatives on May 9, 2013 by a vote of 221 to 207. There has been no action in the Senate.
Previous presidents have also faced the dilemma of being under insurmountable pressure to act in various circumstances with no clear legal authority or conflicting legal demands. Thomas Jefferson concluded that he did not have the authority to buy the Louisiana territory, but did so anyway because it was essential to the national interest.
During the Civil War, Abraham Lincoln often had to take extra-constitutional actions, such as suspending the writ of habeas corpus. In a message to Congress on July 4, 1861, he explained that when forced by grave necessity to break the law, the president must do so, choosing the least unconstitutional option. As Lincoln put it, “To state the question more directly, are all the laws, but one, to go unexecuted, and the government itself go to pieces, lest that one be violated?”
Franklin D. Roosevelt suspended the enforcement of gold clauses in private contracts fully expecting that the Supreme Court would rule against him.
As an economist, my primary concern is the impact on the economy and interest rates of a debt default, which many Republicans in Congress poo-poo as nothing to be too concerned about. In this respect, I think the views of financial market participants should carry special weight. In the run-up to the 2011 budget deal, which narrowly averted a debt default, a number of top Wall Street economists and executives weighed-in on the potential economic and financial consequences.
In an April 2011 note, J.P. Morgan published an extensive analysis of the “domino effect” of a U.S. default that would spread far beyond those that own Treasury securities. As it explained:
Our analysis suggests that any delay in making a coupon or principal payment by the Treasury – even for a very short period of time – would almost certainly have large systemic effects with long-term adverse consequences for Treasury finances and the U.S. economy. These effects would be transmitted through three primary channels: U.S. money funds, the repo market, and the foreign investor community, which holds nearly half of all Treasury securities. Our main conclusions are as follows:
● A technical default raises the risk of a flight to liquidity out of government money funds, potentially triggering an increase in redemptions similar to that seen in 2008.
● Repo markets will be severely disrupted as haircuts are raised and could result in a significant deleveraging event.
● Even if the technical default is cured immediately, foreign demand for Treasuries could be permanently impaired. As a case in point, we note that even without any kind of default, Fannie Mae and Freddie Mac’s move into conservatorship has led to permanently lower foreign sponsorship of GSE [government-sponsored enterprise] debt.
The report said that default could raise yields on Treasury securities significantly and that this impact could last for years owing to permanently reduced foreign demand. It noted that in 2000, the nation of Peru chose for political reasons not to make a debt payment that was due. Although the payment was later made and Peru’s credit rating restored to its previous position, yields on Peru government securities remained about 50 basis points higher for some time thereafter.
Something similar happened in the U.S. in 1979 when the Treasury briefly defaulted. Owing partly to Congress’s failure to raise the debt limit in a timely manner and some problems with Treasury’s equipment for printing checks, some payments that were due on May 3 and May 10 were missed. By May 17, all payments had been made and the Treasury was current with all bondholders. Nevertheless, yields on Treasury bills rose 60 basis points and stayed higher for years.
In a letter to Treasury Secretary Timothy Geithner on April 25, 2011, Matthew Zames of J.P. Morgan, then-chairman of the Treasury Borrowing Advisory Committee, said, “Any delay in making an interest or principal payment by Treasury even for a very short period of time would put the U.S. Treasury and overall financial markets in uncharted territory, and could trigger another catastrophic financial crisis.”
In a survey of its largest clients, J.P. Morgan found that they were expecting a 37 basis point rise in yields on the 10-year Treasury security in the event of a temporary default. However, because they are more risk-averse, foreign investors said they expected a larger yield increase of 55 basis points. Such an increase in yields would raise Treasury’s annual borrowing costs $10 billion in the short run and $75 billion per year in the longer run as maturing debt turns over.
In a May 18, 2011 report to its clients, Morgan Stanley economists took issue with the view that Treasury can stop paying all the rest of its bills, including Social Security benefits, and simply prioritize payments to debt holders, thus preventing a default. The report said that this is a highly impractical solution to the problem. As it explained:
Some have argued that the Treasury can manage its cash in a way that avoids default. For example, see the Wall Street Journal op-eds by Senator Pat Toomey and former Treasury official Emil Henry. However, the approach that they are advocating does not seem at all workable to us. The Treasury’s cash flows are too lumpy to simply prioritize one form of spending over another. For example, we would expect a significant political outburst if the Treasury withheld monthly Social Security checks at the beginning of the month (even though there was sufficient cash on hand to make the payments) just in case they needed this cash to make debt service payments at mid-month. Such a scenario is highly impractical – and probably not even legal.
On June 14, 2011, Federal Reserve Board chairman Ben Bernanke warned Congress about the dire economic consequences of failure to raise the debt limit. As he said:
Failing to raise the debt limit would require the federal government to delay or renege on payments for obligations already entered into. In particular, even a short suspension of payments on principal or interest on the Treasury's debt obligations could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of U.S. government debt, create fundamental doubts about the creditworthiness of the United States, and damage the special role of the dollar and Treasury securities in global markets in the longer term. Interest rates would likely rise, slowing the recovery and, perversely, worsening the deficit problem by increasing required interest payments on the debt for what might well be a protracted period.
Treasury’s cash inflow almost never matches outflow on a daily or even monthly basis. And, as the Morgan Stanley report notes, it is simply not tenable for the Treasury to withhold Social Security payments to make interest payments that may not be due for weeks. (The curious should examine issues of the Daily Treasury Statement to see just how variable Treasury’s tax receipts and payments are.) This point was made by Morgan Stanley economist David Greenlaw in a July 8, 2011 report:
Debt prioritization is not a realistic option. It is being advocated by people who simply do not understand Treasury cash flows. While it is true that the government takes in a good deal more in receipts than it pays out in interest on the debt over the course of a full year, on certain days the government takes in much less than it pays out. For example, the Treasury has an interest payment of about $30 billion due on August 15. On that day, it will take in about $15 billion in tax receipts, so it won't even have enough to make the interest payment alone. Are the proponents of prioritization suggesting that the Treasury should withhold all of the $22 billion social security payment due on August 3, so it can cover a debt service interest payment that is due a couple of weeks later? If so, what is the legal basis for Treasury to do this?
Finally, on Social Security, it is sometimes said that the payment of benefits is never a problem as long as there are sufficient assets in the Social Security trust fund to pay them. The problem is that the Treasury securities in the trust fund are not marketable. If the Treasury lacks the cash to redeem the securities itself there is no practical way of obtaining the cash to pay benefits in the event that the debt limit becomes severely binding. That is why in 1996 Treasury insisted that Congress raise the debt limit sufficiently to cover Social Security benefits or those due on March 1 could not be paid. Of course, Congress did so.
Getting back to the potential problems in financial markets, many Wall Street analysts emphasize the unknown factor. As financial relationships have become more complicated, the full implications of a severe shock to the system cannot be fully anticipated. As UBS Bank economists Maury Harris and Drew Matus have explained:
The main impact on markets would come from sharply reduced liquidity in the U.S. Treasury market, as financial firms’ procedures and systems would be tested by the world’s largest debt market being in default. Given the existing legal contracts, trading agreements, and trading systems with which firms operate, could U.S. Treasuries be held or purchased or used as collateral? The aftermath of the failure of Lehman Brothers should be a reminder that the financial system’s “plumbing” matters. All the legal commitments and limitations in a complex financial system mean a shock from an event that is viewed as inconceivable – such as a U.S. Treasury default – can cause the system to stall. The impact of a U.S. Treasury default could make us nostalgic for the market conditions that existed immediately after the failure of Lehman Brothers.
Voicing a similar opinion, Wells Fargo Bank economist Scott Anderson has said of a default, “It would be an earth-shattering event. It’s taken as given that U.S. Treasuries are a safe asset. Once you question that assumption, it shakes the foundations of global finance and the way it’s been established over the last 50 years.”
University of California, Berkeley, economist Barry Eichengreen, a world-renowned expert on the international monetary system, warned that a debt default could lead to a run on the dollar if foreigners come to feel that the U.S. is being run by irresponsible leaders. As he put it:
If there is a threat to the dollar, it stems not from monetary policy, but from the fiscal side. What is most likely to precipitate a dollar crash is evidence that U.S. budgets are not being made by responsible adults. A U.S. Congress engaged in political grandstanding might fail to raise the debt ceiling, triggering a technical default. Evidence that the inmates were running the asylum would almost certainly precipitate the wholesale liquidation of U.S. Treasury bonds by foreign investors.
On July 22, 2011, Macroeconomic Advisers, a well-known economic forecasting company, warned its clients that a one-month delay in raising the debt limit would reduce real gross domestic product growth by 0.6 percentage points in the second half of the year and the unemployment rate would rise by 0.4 percentage points. Interest rates would rise 20 basis points and the stock market would fall 5 percent. The result would be a “growth recession.”
Congress finally acted in the nick of time and the debt limit was raised on August 2, 2011. Three days later, Standard and Poor’s lowered its rating on U.S. Treasury securities from AAA to AA+. It cited continuing political difficulties in raising the debt limit in a timely manner as a key factor in the downgrade. As it explained:
More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.
Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.
In a July 2012 report, the GAO concluded that the extraordinary actions that the Treasury Department had to take to avoid default forced it to raise money in a less efficient manner that raised the cost of borrowing by $1.3 billion in 2011.
Approaching the current debt limit expiration, Wall Street firms seem somewhat blasé. They appear to feel that the relatively painless increase in the debt limit on February 4, 2013 bodes well for future increases. In an April 18, 2013 report, Goldman Sachs said, “we expect the next debt limit debate to be less disruptive than the 2011 debate.”
On September 18, 2013, economist Mark Zandi of Moody’s Analytics told the Joint Economic Committee he expects the debt limit to be raised in a timely manner. Failure to do so, however, would be debilitating to the economy:
Any delay in raising the debt ceiling would have dire economic consequences. Consumer, business and investor confidence would be hit hard, putting stock, bond and other financial markets into turmoil.
This was clearly evident in the near-debacle that occurred in summer 2011, when lawmakers raised the debt ceiling at the very last minute. Brinkmanship nevertheless undermined consumer confidence, sent stock prices reeling, and caused credit default swap spreads on U.S. Treasury debt to widen sharply.
Economists generally agree that policy uncertainty is bad for the economy. According to one analysis, the uncertainty caused by the debt limit debate in 2011 was significantly greater than the terrorist attack on September 11, 2001 or the collapse of Lehman Brothers in September 2008.
The historian Joe Thorndike is inclined to think that debt limit debates have, historically, been helpful in focusing the Congress’s attention on long-term fiscal trends. That is an argument that may have been salient before enactment of the Budget Act of 1974, which requires Congress to examine aggregate budget trends on a yearly basis. Therefore, I believe the debt limit is simply redundant in that sense.
The core problem is that relations between the two major parties in Washington are deeply poisonous today for reasons only peripherally related to the budget. That makes the debt limit too easy a hostage for the party not holding the White House to use for extortion of demands that lack a democratic mandate in the form of majorities in the House and Senate plus control of the White House.
If the consequences of such brinksmanship fell only on elected officials, it wouldn’t matter. But given the potentially large economic costs of a debt default, the U.S. economy and average Americans could suffer a considerable amount of collateral damage.