Tuesday, May 31, 2011

More on the Politics of the Debt Limit

On ABC’s “This Week” program on Sunday, Tim Pawlenty, the former governor of Minnesota now running for the Republican nomination for President, said that the debt limit should not be increased.  Here is the transcript of his responses to some of the questions Christiane Amanpour posed to him on the subject:

PAWLENTY:  I don't think we should raise the debt ceiling.  And if the Congress moves in that direction, the president, they better get something really good for it.  It better be permanent, and it better be structural, like a balanced budget amendment and like permanent caps and limits on spending that are specific, not just aspirational.
AMANPOUR:  Are you being political right now or do you really, really mean that one should not raise the debt ceiling, given the fact that most economists say that it would -- it would make a cascade of catastrophic economic situations?
PAWLENTY:  Well, there are some serious voices challenging that very premise.  And the answer is nobody really knows, because we've not been at this point before.
This is not a new position.  Mr. Pawlenty wrote an article espousing this position for the Washington Post in January.  To make sure that potential supporters don’t miss this, there is a link to the Washington Post on his website.
The press has told us that Pawlenty is one of the frontrunners for the Republican nomination and is a serious candidate.  But this is not a serious position, though the fallback of budget concessions from the Administration in return for passing the debt limit is probably his real position.  However, the Republicans in Congress have also to deal with Congressional Democrats as well as the Administration, including the Democrats who control the Senate.  The House Democrats may also be significant, since there may not be enough Republican votes to pass debt limit legislation in the House, especially after the Senate has reworked it and perhaps even before then.
But Pawlenty should know better than to rely on “serious voices” for his announced position of not raising the debt limit.  This is all about politics, as he knows, and it is hard to attribute any seriousness to a position that Treasury should default on its obligations.  After all, credit judgments are partly based on character, and what type of character does it show if a country willing does not pay its bills, even though it has the wherewithal to do so?
Pawlenty’s position on the debt limit demonstrates a perceived need to pander to the Tea Party elements of the Republican electorate.  On the surface, at least, Pawlenty is showing them more deference than he is to Iowa farmers, now that he has announced that he believes federal ethanol subsidies should be phased out.  (However, this may not be as courageous as it first appears and as the editorial page of The Wall Street Journal would have us believe.  The politics of ethanol are changing, and, in any case, Governor Pawlenty found a way to help the ethanol industry in a way that does not involve subsidies – he proposed and signed into law a Minnesota requirement that gasoline sold in that state for use by motor vehicles contain 20% ethanol by 2013.  Who needs subsidies when you have that type of mandate?)  
The Tea Party movement is causing some schisms to become apparent in the Republican Party, and Mr. Pawlenty and others are not showing much courage in dealing with it.  Nick Carey writing for Reuters discussed this in a May 17 article: “Special report: Stuck between the Tea Party and a hard place.”  According to the article, at an April 25 meeting with Tea Party activists in Ohio, House Speaker John Boehner replied “yes” when asked if Republicans would vote to increase the debt limit.  The article goes on to describe what Boehner subsequently said and the reaction to it:
“And we're going to have to raise it again in the future,” he added.  With the mass retirement of America’s Baby Boomers, he explained, it would take 20 years to balance the U.S. budget and 30 years after that to erase the nation's huge fiscal deficit.
That answer incensed many of the Tea Party activists, for whom raising the debt limit is anathema.
Concerning the Tea Party’s pressure to move the Republican Party to its beliefs, the article comments:
That leaves Boehner stuck between the Tea Party and a hard place.  If he pushes too hard on cuts, that will rattle the Republican Party's powerful Wall Street wing, potentially roiling the markets and unsettling the broader electorate.
But backing down will also hurt him.  “After accusations he didn't do enough in the budget battle, Boehner has to have something real to take back to conservatives or he's in trouble,” said James McCormick, a professor of political science at Iowa State University.  “He’s boxed in between two components of the Republican Party. Obama knows that and is not under the same pressure.”
In other words, as Speaker of the House, Boehner has a responsibility to get debt limit legislation passed, whatever the Tea Party might think.  He is hoping that to negotiate a deal that will make this easier.  President Obama has the stronger hand, and has the ability to appear totally unfrazzled no matter what is happening, but we will have to see what he and the Democrats in Congress are willing to give Boehner.  Unless the Administration wants to play real hardball, which may disconcert the markets and may not be politically wise, the Democrats will need to give Boehner something to sell to his caucus.  

Friday, May 27, 2011

Debt Limit Posturing

On May 25, twenty-three Republican senators sent a letter to President Obama (while omitting his name anywhere on the actual letter) stating that "it is irresponsible not to develop robust contingency plans," a "Debt Ceiling Budget," in case the Congress does not pass an increase in the debt limit. They do not say that this requires any legislative action, which is not going to happen in any case. They do, however, say that the Administration should work with Congressional budget experts on this. The senators, of course, know that this letter will be ignored. This is not serious.

It is surprising that those opposed to the Obama Administration and to increasing the debt limit seem willing, even eager, for the Congress to give up the power of the purse to the Executive branch. In this hypothetical world, what makes them think they would be happy with the choices the President would make?

Moreover, while I have not seen any legal analysis of this in the debt limit context, Nixon-era legislation limiting the President's ability to impound funds may limit the Executive branch's ability to deny funds for certain programs in order to hoard cash to pay interest or other priorities. (For those interested, the relevant portion of the U.S. Code starts here.)

If the senators are proposing legislation, they cannot possibly think that the Administration in the next few weeks will agree with Congress to a budget that requires no increase in the debt subject to limit, including the debt held by the trust funds. It doesn't even matter what the Administration thinks. No such budget could receive Congressional approval. Some of these senators must be afraid of a Tea Party revolt in their states, such as that which felled Senator Bennett of Utah. This is just plain posturing, which is not helpful for the reputation of the Senate as a serious deliberative body.

Clinton, the WSJ, and Others on the Debt Limit and “Technical Default”

I continue to be amazed by the things some people who should know better say concerning the debt limit and a “technical default.”  For example, on Wednesday at the Peter Peterson Foundation Fiscal Summit (a Washington conference for deficit hawks), former President Bill Clinton said:  “If we defaulted on the debt once for a few days, it might not be calamitous.”  Apparently, he must have gotten an earful about this remark after the conference, because his spokesman said a few hours later that Clinton had “inadvertently misspoke,” and what he really meant to say was… (You can read about it here.)

The Wall Street Journal, of course, could not resist having some fun with this by writing an editorial – “Clinton vs. Geithner: The former President channels Druckenmiller.”  The WSJ has been pushing the idea that a “technical” default would not be so bad if it is the road to their view of fiscal sanity (large spending cuts, no tax increases), as if that could be negotiated in a few days.

Fortunately, more sensible views have been expressed.  To the extent this is a partisan issue, it is for the most part political posturing.  Most Republicans and Democrats (with some exceptions such as Emil Henry) who are familiar with financial markets and Treasury debt management operations agree that the debt limit is a terrible and usually ineffective tool to achieve political ends, whatever their views may be on spending and tax issues.

Jay Powell, a former Treasury Under Secretary for Domestic Finance in the George H.W. Bush Administration, for whom I once worked, rebutted the WSJ/Druckenmiller thesis in a letter to the editor that was published on Wednesday.  Mr. Powell notes that “most market participants, business leaders and current and former Federal Reserve and Treasury officials of both parties” oppose threatening default as a way of achieving deficit reduction.”

J.P. Morgan published a report on April 19 on why technical default would be calamitous:  “The Domino Effect of a US Treasury Technical Default.”  This report sees a technical default as leading to a run on money market mutual funds, problems in the repo market due to increased haircuts, and a decrease in foreign appetite for Treasuries.  The report also warns that a delay in passing the debt limit legislation will have adverse consequences:  “Because the tail risks from a technical default are so large, a prolonged delay in raising the debt ceiling seems likely to impact markets well before a default actually occurrs [sic].  These effects could include liquidity shortages over the late June/July period as borrowers attempt to raise additional cash and increase the tenor of their borrowings, large auction concessions especially if Treasury were to postpone an auction, increases in option volatility that cover the June/July period, and generally weaker demand for Treasury securities as uncertainty on whether the debt ceiling will be raised grows [emphasis in the original].” 

As far as market problems go, I would add to the J.P. Morgan analysis the confusion over how to calculate accrued interest for trading and repo purposes and what to do in this connection with already concluded transactions.  It would be a heavy burden to reconstruct all trades during a given 6-month coupon payment period or even to trace back ownership to the missed coupon payment date as the market continues to trade, and the Securities Industry and Financial Markets Association (“SIFMA”) would have to come up with a suggested trading convention fairly quickly in an extremely nervous market environment.

Wednesday, May 18, 2011

QE2 and Treasury Securities in Private Hands – Is June the End of the Fed Monetizing the Deficit?

As market participants watch the debate over increasing the debt limit proceed and consider how to adjust their trading strategies for the upcoming end of the Federal Reserve's second quantitative easing program ("QE2") in June, I thought it would be interesting to look at Treasury debt held in private hands since November 2010, when QE2 started. The numbers indicate that federal debt held in private hands decreased during the period in spite of the large budget deficit which is being financed.

On November 3, 2010, federal debt held by the "public," which excludes government trust fund holdings but includes Federal Reserve holdings, stood at $9,134 billion, according to the "Daily Treasury Statement." On that day, the Federal Reserve reports holding $842 billion of Treasury securities outright, according to Federal Reserve Statistical Release H.4.1. On May 4, 2011, the comparable numbers were $9,698 billion and $1,442 billion. In other words, ignoring some possible accounting and definitional differences between Treasury and Federal Reserve statistics, the federal debt in private hands decreased from $8,292 billion to $8,256 billion from November 3 to May 4.

It should be noted, however, that the decrease in private holdings of federal debt is more than accounted for by Treasury's reduction of outstanding Treasury bills issued in connection with the Supplementary Finance Program (a program I have discussed and criticized in previous posts – here, here, and here.) On November 3, Treasury had $199.6 billion of bills outstanding to finance this account; this had declined to $5 billion on May 4. (The Treasury has let the bills run off for this program because of the debt limit impasse.)

The Supplementary Finance Program, which assists the Federal Reserve in draining reserves from the banking system, is in essence Treasury borrowing of cash it does not need. If the Fed is targeting overall bank reserves, then the Fed would have had to counteract the increase in bank reserves due to the decrease in cash in the Supplementary Financing Program account by selling Treasury securities or other securities into the market. I do not know how the Federal Reserve adjusted its open market operations in reaction to the reduction in the Supplementary Financing Program account.

If, come June, the Fed begins maintaining the size of its balance sheet but does not increase it, there will be an increased supply of Treasury securities that the market will have to digest. Also, if, after the debt limit is increased, Treasury decides (probably in consultation with the Fed) to increase the amount in the Supplementary Financing Account to perhaps around $200 billion, this will further increase the amount of Treasury securities in the market.

One assumes that the Fed is considering how the market will react to the supply effects as it decides what to do next. Treasury has no choice but to continue to issue securities, whether the Fed helps by buying in the secondary market or not.

(Note: the figures for federal debt include non-marketable Treasury securities such as U.S. Savings bonds and State and Local Government Series Securities, which state and local governments invest in for tax reasons.)

Tuesday, May 17, 2011

The Policy Dispute Underlying the Debt Limit Debate

As the debate about the debt limit heats up over the next few months, there will be continued mention that the fiscal path we are on is unsustainable. Some will argue that the best way to correct that is to "tear up" the U.S. government's "credit card." Many of the arguments of those opposing an increase in the debt limit will be foolish, and it will often be hard to tell whether the speakers believe them or not. However, for all Speaker Boehner's tough talk, which I take to be a negotiating position and an attempt to placate the new members of his caucus, it is fairly clear he recognizes that he has a responsibility to get an increase in the debt limit enacted before a default of some sort occurs. As some people continually need reminding, the need to increase the debt limit is the result of laws Congress has already passed.

While there are some clear political reasons that the Congressional Republicans will take this to the brink, there is also a genuine policy dispute underlying this. The aging of the U.S. population dictates that Social Security and Medicare will take a larger share of the GDP than they have in the past unless the programs are made substantially less generous. These programs, though, enjoy broad public support. If the programs are not made less generous, taxes will ultimately have to be increased. This does not necessarily mean a general increase in marginal tax rates, because tax reform measures, reduction of many "tax expenditures," and, perhaps, the introduction of a value added tax, which most other industrial nations impose, could serve to generate more revenue.

Those who want to resist tax increases have seized on the current deficit and the need to increase the debt limit as a way to force changes in "entitlements." They point to polls that state that Americans want the deficit to be reduced and do not favor an increase in the debt limit. They glide over the fact that the principle causes of the current deficit include the Bush tax cuts, which have now been extended with the agreement or acquiescence of the Obama Administration, the poor economy, and defense expenditures due to military intervention in Iraq, Afghanistan, and, now, Libya. Also, leaving aside defense expenditures, they do not explain how cutting government expenditures currently will help grow the economy, which is necessary for the reduction in the next few years of the current budget deficit

The problem for those seizing on the current economic and political situation to make changes or "massive cuts," as Stanley Druckenmiller favors, in entitlement, as well as recuing current government spending, is that once one departs from generalities and offers specifics, the public is not pleased. References to the need to be "adult" or "serious" about this do not change this reality.

In a previous post, I have argued that the public's concern about the deficit is in reality a reflection of anxiety concerning the current economic situation. Nevertheless, the current demographic situation does suggest that something needs to be done about the long-term fiscal situation. Since the public hates both tax increases and spending cuts, some mixture of the two would seem to be in the offing. But, eventually, we will need to make more changes to our health care system, of which Medicare is a part. The U.S. has higher administrative costs than other industrial countries and spends more per capita on health care but has little, if anything, to show for it in terms of public health results. As the current disputes on the recently enacted health care law indicate, making more changes will be difficult, but I believe it is necessary and this will become clearer over time. All health care systems have their problems, but we need a better system than we currently have.

(On health care issues, I continue to recommend T.R. Reid, The Healing of America: A Global Quest for Better, Cheaper, and Fairer Health Care. In an afterword in the paperback edition, Mr. Reid writes about "Obamacare": "But the sad truth is that, even with this ambitious reform, the United States will still have the most complicated, the most expensive, and the most inequitable health care system of any developed nation. The new law won't get us to the destination all the other industrial democracies have reached: universal health care coverage at reasonable cost.")

Monday, May 16, 2011

Tough Talk on the Debt Limit

The Opinion pages of this past weekend's (May 14-15) edition of The Wall Street Journal devote a considerable amount of space arguing that a "technical default" on the debt would not be so bad, especially if "it serves the purpose of fixing America's fiscal mess," as an editorial "The Armageddon Lobby" argues. In addition to the editorial, a sizable number of column inches are devoted to an article based on an interview with Stanley Druckenmiller, who once worked for George Soros – "What If the U.S. Treasury Defaults?" Mr. Druckenmiller argues that it is more important that there be fiscal reform than avoiding a "technical default."

Mr. Druckenmiller posits two options for investors in 10-year Treasury notes. The first is a delay on a coupon payment, but in exchange for that there would be "massive cuts in entitlements and the government is going to get their house in order so my payments seven, eight, nine, 10 years out are much more assured." His second option is getting paid on time currently, "[b]ut we're going to continue to pile up trillions of dollars of debt and I may have a Greek situation on my hands in six or seven years." He says it is a "no-brainer" that the first option is preferable.

Of course, this is a ridiculous argument, since these are not the choices. There is no way that "massive cuts" in Social Security and Medicare, which enjoy considerable popular support, are going to be negotiated in a few weeks, whether or not there is a default. It is also not conducive to achieving consensus on entitlement programs if one side is threatening what many believe would be a financial calamity if they do not get their way.

As I argued in the previous post, the tough talk on the debt limit is essentially hiding a weak hand. If we go to the brink on the debt limit, there will come a day when Treasury will announce that it does not have enough cash to meet the next day's obligations. The Treasury currently projects that this will happen in early August. It may or may not fall on a Social Security payment or on an interest payment date. That depends on factors such as the cash coming in and out of government accounts, the flow of trust fund redemptions and new investments in non-marketable Treasury securities, and perhaps the presence of any uninvested cash in the trust funds due to a Treasury's lack of authority to issue new securities. (Redemptions of non-marketable securities to pay Social Security benefits lowers the debt subject to limit and investment of Social Security benefits increases the debt subject to limit, though these transactions are between different government accounts and do not involve borrowing from the public.) However, there will always be a Social Security payment and interest rate payment looming in the near future.

No one is quite sure what happens when we hit the day when Treasury runs out of cash. It is not clear what the legal and operational options are in this situation for the Treasury. But my guess is that if Treasury does not make some or all the payments due on a particular day, Congress will rush through a law at warp speed giving the Treasury at least temporary authority to issue securities and that Treasury will use that authority on the day it is enacted. There would likely be a bad market reaction and reputational damage. What I continue to think is much more likely, though, in the absence of a political agreement on budget issues is that Congress will pass some sort of legislative fix before the day Treasury would otherwise run out of cash.

Wednesday, May 11, 2011

The Debt Limit, Social Security, and the Republicans’ Negotiating Hand

For all the tough talk coming from the Republicans in Congress, including Speaker John Boehner's May 9 address to the Economic Club of New York, a look at the calendar and the schedule for Social Security payments suggests that the Republicans negotiating strength is not as strong as they are suggesting.

The largest dollar amount of Social Security benefit payments hit the Treasury's account at the Federal Reserve on the third of the month if that is a business day. Electronic fund transfers for those who filed for Social Security benefits prior to May 1, 1997 are made on that day. The current amount of payments for the third day of the month is nearly $22 billion. Other important Social Security payment dates are the second, third, and fourth Wednesdays of each month. Those who filed on or after May 1, 1997, are paid on those days, depending on the day of the month they were born. The transfer for Social Security benefits out of the Treasury's account for each of these three Wednesdays is running currently at a little over $9 billion.

In his May 2 letter to Congress, Treasury Secretary Geithner indicates that, using some accounting stratagems relating to the debt subject to limit, Treasury will likely have enough cash to meet its obligations until August 2. If Congress has not passed an increase in the debt limit by August 2, it will be under enormous pressure to do something, if only a temporary or a small increase in the debt limit, so that Treasury can rush out a cash management bill in order to have enough cash to pay Social Security benefits.

If there is no political compromise on budget issues and a permanent and sufficiently large increase in the debt ceiling is not enacted, one can see this scenario playing out each time the Treasury is running out of cash and a large payment is due the following day. The other big payment day in August besides the four Social Security payment days is the 15th, when interest is to be paid on Treasury notes and bonds with semiannual coupon payment dates of February 15 and August 15. On February 15, the amount of interest paid was $29.7 billion.

Given how politically unrealistic Speaker Boehner's demands are, it looks increasingly likely that the debt limit impasse will continue to the brink, and there is even the small possibility that Social Security payments to be made on August 3 will be delayed. One would think that would be political poison for the Republicans no matter how hard they would furiously attempt to place the blame on the Administration.

If no compromise on budget issues is reached with the Administration, it is unclear how long the Congressional Republicans will want to prolong the debt limit impasse. Small or temporary increases in the debt limit will mean more difficult votes. The political reality is that the Republicans cannot achieve through debt limit legislation large spending cuts unacceptable to the Administration.

Unfortunately, the uncompromising talk on the debt limit will no doubt make some investors nervous as each big payment date approaches.