Debt Limit Follies

The debt limit showdown will soon be before us. It will be riveting theater for those interested in politics and has the potential to be unnerving to financial market participants. We will likely see irresponsible statements and political posturing. Politicians threatening that they are prepared for the government to default on its debt unless they get their way are being reckless with the country's financial reputation.

Almost all political appointees I worked for at the Treasury believe that the debt limit exercise is a total waste of time, that default would be catastrophic, and that it would be preferable, if Congress insists on debt limit legislation, for necessary increases in the limit to be accomplished by legislation unencumbered with other matters and enacted in a timely matter. I say almost all, because there is one former senior Treasury official who, once he had left office, appeared to me to downplay the consequences of default. I hope he has changed his mind. In any case, arguing that default is no big deal if it is corrected a few days later is wrong. Just think about what would happen to the trading of Treasury securities after a default and the task of getting interest payments to the right holders after the fact. Also, of course, there are the little matters of a foreign exchange crisis and a global financial panic. Imagine the damage to the financial reputation of the U.S. and the long-term impacts to U.S. world financial leadership.

There is always the danger that some might be tempted to mislead themselves about the severity of default because it gets in the way of their political goals. But if people are serious about fiscal responsibility, they should not threaten default.

Of course, default is exceedingly unlikely. As I wrote in a previous post:

"Once Treasury has used a particular maneuver to remain solvent during a debt limit crisis, Congress knows about it and expects Treasury to use it again. Meanwhile, Treasury starts sending increasingly frantic letters to the Hill asking for an increase.   

"While this is all theater, and everyone knows that Congress will eventually do the right thing and pass debt limit legislation, it is not costless. There are market effects as Treasury cancels auctions and takes other actions such as suspending sales of special securities to state and local governments. Also, top Treasury officials, including the Secretary, have to spend an inordinate amount of time monitoring the level of the debt, the Treasury's cash balance, and the daily projections of cash inflows and outflows. They also have to consider how to deal with the political problem. This time drain diverts them from dealing with real issues, because of the requirement to handle this artificial crisis."

I also wrote: "The fear during a debt limit crisis is that Congress or the Administration may carry the charade too far, and the Treasury will not have enough cash to make an interest payment or to make payments, such as the large Social Security payments at the beginning of each month. This has never happened." As former Treasury Secretary Rubin stated in a masterpiece of ambiguity (whether or not the ambiguity was intentional), default is "unthinkable."

Some members of Congress will again threaten what has never happened in order to pressure the Administration. It will be a real political test for the President and Secretary Geithner. It is a test that they should not have to undergo.

With respect to the members of Congress doing the threatening, it is hard to know whether they really believe in what they are saying. Some might; many probably just think it is a useful way to try to score political points, since they believe that at the end of the day default will be avoided.

While it is legitimate to have a full debate on the role of government going forward, and specifically on tax and spending policies, the debt limit is not the appropriate legislative vehicle for this debate. The public and the rest of the world will be aghast as default is threatened. But it seems there is no way for this to be avoided in the coming months.