Rebels without a Clue
Thursday, July 28, 2011
All the talk about the U.S. government hitting the brick wall of bankruptcy next week misses many of the finer points of fiscal mechanics.
The precise statement of the problem comes in three parts.
First, if forecasts of volatile Treasury deposits and withdrawals come in on track, the Treasury's account at the Federal Reserve would go into overdraft around August 2. This is an uncertain projection because the United States is spread over half a continent and has many global entanglements. Figuring out the balance in the government's checking account each day, let alone a week in advance, involves guess work.
Second, if the secretary of the Treasury limits himself to accounting devices for which there is recent precedent, then he will not be able to replenish that cash balance by finding room under the existing debt ceiling.
By opting for one of these three options, the Treasury secretary opens himself up to a hostile Congress for censure or impeachment. But he would not default.
Third, the fiscal agent of the Treasury and provider of that checking account, the Federal Reserve, is prohibited by law from lending directly to the Treasury. As a consequence, it cannot plan on the Treasury account being overdrawn at the end of the day. Thus, the Fed will have to seek instructions from its principal as to which payments to honor and which to pend. Only if the Fed is told not to make scheduled interest and principal payments would the U.S. government go into default.
Government inflows have run a bit stronger in recent weeks, so the Treasury might be able to push this day of reckoning a week or so into the future. More difficult to reckon is what the Treasury will do as the true date approaches and how global financial markets will react.
As for the Treasury, Alexander Hamilton casts a long shadow over its likely action. As first secretary of the Treasury, he established that the government of the United States would always honor its obligations. This intent was underscored after the Civil War in the Fourteenth Amendment to the Constitution. Written into the law of the land is the presumption that "the validity of the public debt of the United States, authorized by law ... shall not be questioned."
Hamilton's successor, Timothy Geithner, presumably will go to great lengths to avoid missing a payment of interest or principal on the debt. But, to honor that constitutional precedent, he may have to break (or, more charitably, to interpret generously) some other laws.
Figuring out the balance in the government's checking account each day, let alone a week in advance, involves guess work.
Three obvious candidates come to mind.
First, the most forthright option is for the secretary to explain that his existing legislative instructions are mutually inconsistent. He can further assert that the Constitution trumps the Second Liberty Bond Act of 1917 which established the notion of public debt subject to limit. National debt clocks could go back to ticking as the Treasury then recommenced its regular auction of securities.
Second, the nation owns about a quarter billion ounces of gold, valued at the quaint old figure of $42 2/9 per ounce. This stock serves as collateral for about $11 billion of gold certificates on the books of the Federal Reserve. The Treasury and the Fed could swap the old certificates for new ones based on a value closer to the current market price of $1,650 per ounce. To balance its books, the Fed would credit the Treasury's account an additional $400 billion or so. This should be enough for even our improvident government to run for a few more months. Such an accounting transaction has the attraction of being done before in identical circumstances, as pointed out by my colleague Alex Pollock. In 1953, the Fed similarly "monetized" the gold after the Congress failed to pass an increase in the debt ceiling. This by the way, highlights the bipartisan nature of debt-ceiling dramatics. At the time, Republicans held the presidency and majorities in both chambers of the Congress.
As first secretary of the Treasury, Alexander Hamilton established that the government of the United States would always honor its obligations.
Third, even if the U.S. Treasury cannot borrow from markets or the Fed, it controls two entities that can. The government sponsored housing enterprises, Fannie Mae and Freddie Mac, are under conservatorship. They could lend to the Treasury or use their large balance sheets to hold illiquid government assets in a swap for much-needed liquidity for the Treasury.
These three options, and more that government lawyers can gin up, are unpalatable, set bad precedent, and probably break a few laws. By opting for one of them, the Treasury secretary opens himself up to a hostile Congress for censure or impeachment. But he would not default.
True, there are steps short of default should the Treasury's cash at hand and expected income be insufficient to meet anticipated outlays. With the national unemployment rate hovering around 9 percent, a lot of American households have been put in similarly tough circumstances. Like them, the secretary can line up scheduled payments and make only those that keep the bank account in the black. As long as principal and interest payments are kept at the top of the list and the Treasury plans ahead, bond-market bailiffs can be kept at bay.
Only if the Fed is told not to make scheduled interest and principal payments would the U.S. government go into default.
No one, however, playing the ongoing game of fiscal chicken should bank on such prioritization going smoothly. People expecting payments would not be receiving them and would cut back on their own outlays. Everyone would be more uncertain and cautious because a government not paying its electricity bill promptly sends a bad signal about future payment prospects. Aggregate demand would lurch downward.
Investors, particularly foreign ones who have just seen the same movie play out in Europe, might recoil. This would have adverse consequences for the foreign exchange value of the dollar and the prices of oil and other commodities. The flight from dollar assets would pick up in intensity if one or more of the ratings agencies saw the breakdown in the fiscal policy process as reason to knock the U.S. government from its triple-A pedestal.
Relying on the kindness of others is always a risky business and especially so in a politically charged environment.
Congressional Republicans should keep in mind that they would be exposing themselves to a very specific and sizable threat. Prioritization only works if the administration executes it deftly. The voting public's considerable concerns would have to assuaged. Vendors would need to be reassured that payments were only delayed. Treasury officials would have to be dispatched to foreign capitals to hold the hands of official investors of our government securities. And regulators would have to remind rating agencies that the long-run prospects of the U.S. government were undimmed.
But would the administration act that way if the debt-ceiling stand-off ended with ugly recriminations? Prioritization could be designed to maximize the political backlash by making sensitive payments, such as those to Social Security beneficiaries, first. Moreover, officials could plausibly deem that government employees not being paid should stay home.
The classic cinematic treatment of a game of chicken is in Rebel without a Cause. The movie revolves around teenagers, fueled by testosterone and with little thought of the future, dueling in hot rods. It ends with the character played by Sal Mineo going over a cliff because his coat gets caught in his car-door handle.
Mistakes happen and can be costly when the stakes are high.
Vincent Reinhart is a resident scholar at the American Enterprise Institute.
FURTHER READING: Reinhart says we have been “Getting Lehman Profoundly Wrong,” discusses “QE in Theory—and Practice,” reviews “A Year of Living Dangerously: The Management of the Financial Crisis in 2008,” and makes “The Case for Quantitative Easing.”
Image by Darren Wamboldt/Bergman Group.