Dancing on the edge of default

Reuters

US Treasury Secretary Jack Lew speaks with Carlyle Group co-CEO David Rubenstein during an onstage interview at the Economic Club of Washington DC, in Washington, September 17, 2013.

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  • The shame is that the Congress threatens to put Lew in the position to have to choose the lesser of 2 evils.

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  • And it is a waste because the United States government is not going to default, ever.

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  • This recognition of the depth of the chasm ultimately drives them to compromise each and every time.

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Even as the White House insists there is no alternative to congressional action to raise the federal borrowing limit by Oct. 17, the options for an end run have spurred a raging debate, with armchair experts in the blogosphere as well as some of the top legal scholars in academia all weighing in.

Former President Bill Clinton, Senator Max Baucus and Representative Nancy Pelosi, all Democrats, have also gotten into the act, with the three urging President Obama to at least consider invoking his powers under the 14th Amendment to break the logjam.

One of the sharpest economists on Wall Street, Vincent Reinhart of Morgan Stanley, has taken a close look at the options, both from a practical standpoint as well as how markets and investors are reacting. Here is his take.

– Nelson D. Schwartz


The market price to insure against default by the United States government over the next five years is heading toward half a percentage point. The number of Google searches for the terms “government default” and “Social Security payment” have moved to all-time highs. Any prudent financial firm is assigning its operational risk management team to think the unthinkable: “What happens if the United States Treasury defaults on its debt?”

"12 Things You Want to Know About the Shutdown and Debt Ceiling," from economists at Morgan Stanley.
This is just part of the waste and worry created by the ongoing standoff on the budget and the failure to raise the debt ceiling. And it is a waste because the United States government is not going to default, ever.

As political theater, the debt ceiling is not a useful threat, because politicians are basically threatening to shoot themselves as they will rightly shoulder the blame for the serious global economic consequences of a default.

This recognition of the depth of the chasm ultimately drives them to compromise each and every time. But why do they repeatedly dance so close to the edge? They flirt with such danger because, deep down, people on the Hill believe that the secretary of Treasury will save them from the consequences of their action at the last minute.

After all, the Treasury has indicated that it runs out of cash on Oct. 17 as long as the secretary limits himself to extraordinary measures that have precedent. Will he or won’t he? In that regard, the Hill standoffs over the years are similar to two siblings beating each other up in the backyard but always expecting their mother to step out on the porch and tell them, “You better stop before somebody gets hurt.”

Our elected officials are counting on the secretary to be the adult.

There are always other items below the line drawn by precedent. No official will ever admit that because it is the cataclysmic nature of default that drives politicians to the table. Most of these maneuvers are of questionable legality and worse precedent because if they were easy, they would have already been used.

The list probably includes warehousing revalued gold, extending the disinvestment of the Civil Service funds to other trust funds or swapping out the Federal Reserve’s holdings of Treasury securities for debt not subject to public limit. The list also includes the possibility of prioritizing payments to make principal and coupon obligations when due. By the way, the trillion dollar coin is too clever by half. If you are going to violate the spirit of the debt ceiling, then violate the debt ceiling.

But there is a bigger picture that is relevant and dominates the discussion. If the Treasury is unwilling to stretch the definition of extraordinary measures, on the day that the Federal Reserve predicts the Treasury will run out of cash in its account and the Treasury is bound by the debt ceiling, it suspends all payments and awaits instructions from the Treasury. As a result, the government’s principal economic officials will face the prospect of violating one of these three laws:

1. The Second Liberty Bond Act of 1917 that establishes the debt ceiling;

2. The Federal Reserve Act that prohibits the Fed from lending directly to the Treasury; or,

3. The 14th Amendment of the Constitution, which holds that the debt of the United States government, lawfully issued, will not be questioned.

They have to break a law. At the end of the day, officials will avoid violating the Constitution by indicating that they have been given inconsistent instructions and are obeying the one with the most important precedent.

If it is the secretary of Treasury that decides to contest No. 1, then the Treasury will issue debt and raise cash. However, the debt arguably does not have the protection of Amendment 14, as it was not necessarily lawfully issued, so it may not be default free. That is, similar to some proposals to resolve the European fiscal crisis, the Treasury will issue “red” bonds to pay the maturing principal and interest on “blue” bonds. Market participants will figure out how to price those securities on the assurance that the reds turn blue when the debt ceiling is increased.

If it is the chairman of the Federal Reserve that decides to contest No. 2, then the Treasury account goes into overdraft and all Treasury operations continue.

An official anticipating stretching the law ranks alternatives by precedent, punishment as specified in the law and standing as to who can claim a violation of the law. Either a secretary of the Treasury who holds No. 3 as the overriding instruction or a chairman of the Federal Reserve who waives No. 2 saves the global financial system and, at most, risks being impeached or fired. That seems to be a reasonable risk and reward trade-off.

Treasury Secretary Jacob Lew can look out the back of his building and see a statue of Alexander Hamilton. He will not be the first secretary to break the Hamiltonian promise. The shame is that the Congress threatens to put him in the position to have to choose the lesser of two evils.

Mr. Reinhart, former head of the Federal Reserve’s monetary division, is the managing director and chief United States economist for Morgan Stanley.

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About the Author

 

Vincent R.
Reinhart
  • Vincent Reinhart, a former director of the Federal Reserve Board's Division of Monetary Affairs, joined AEI in 2008 after working on domestic and international aspects of U.S. monetary policy at the Fed for more than two decades. He held a number of senior positions in the Divisions of Monetary Affairs and International Finance and served for the last six years of his Federal Reserve career as secretary and economist of the Federal Open Market Committee. Mr. Reinhart worked on topics as varied as economic bubbles and the conduct of monetary policy, auctions of U.S. Treasury securities, alternative strategies for monetary policy, and the efficient communication of monetary policy decisions. At AEI, he has continued his work on all of the above in addition to research on key economic variables before and after adverse global and country-specific shocks, policy mistakes leading to the 2007-09 financial meltdown, and the implementation and impact of quantitative easing.
  • Email: vincent.reinhart@aei.org

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