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.

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