A Few Debt Limit Observations

Treasury Secretary Janet Yellen was very careful in how she responded to questions from George Stephanopoulos on Sunday about any contingency plans the Administration might have if Congress does not increase the debt limit before the Treasury runs out of cash. She said that there were no good options and that she did “not want to consider emergency options.”

The news media, though, has been highlighting the use of the 14^th Amendment to the Constitution to allow the Treasury to continue issuing Treasury securities. In that Amendment which was put into the Constitution in the aftermath of the Civil War, there is the following sentence: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” There is some ambiguity here, and the phrase “authorized by law” might be cited by those who do not believe that the 14^th Amendment provides a way to avert an economic disaster.

Laurence Tribe, a noted Constitutional expert, used to believe that the 14^th Amendment was not a way for the Treasury to ignore the debt limit, but in a recent article in the New York Times, he explains why he has changed his mind.

“The question isn’t whether the president can tear up the debt limit statute to ensure that the Treasury Department can continue paying bills submitted by veterans’ hospitals or military contractors or even pension funds that purchased government bonds.

“The question isn’t whether the president can in effect become a one-person Supreme Court, striking down laws passed by Congress.

“The right question is whether Congress — after passing the spending bills that created these debts in the first place — can invoke an arbitrary dollar limit to force the president and his administration to do its bidding.

“There is only one right answer to that question, and it is no.

“And there is only one person with the power to give Congress that answer: the president of the United States. As a practical matter, what that means is this: Mr. Biden must tell Congress in no uncertain terms — and as soon as possible, before it’s too late to avert a financial crisis — that the United States will pay all its bills as they come due, even if the Treasury Department must borrow more than Congress has said it can.”

There has been speculation about the litigation that might follow if the Administration were to invoke the 14^th Amendment. I wonder about that. First, I am not sure who would have standing to sue. I am not sure if the Supreme Court would say that Speaker McCarthy by himself has standing, and I am not sure if he got a vote on the House floor to litigate what the courts would do. In any case, given the financial market turmoil that would likely occur, I doubt that politicians would think that it would be in their benefit to try to call into question debt the Treasury issued above the debt limit.

Also, there are practical difficulties in considering that some of the public debt is invalid. For example, Treasury issues 3-month and 6-month bills every week. The 3-month bills, once issued, are indistinguishable from the 6-month bills already issued which mature on the same date (technically, the bills maturing on the same date have the same CUSIP number). There would be no way to determine which of these bills when issued breached the debt limit if Treasury issued an amount more than what it needed to pay off the maturing bills.

I think the House would try to get at President Biden some other way, perhaps even including commencing impeachment hearings. There is of course no way that there would be enough votes in the Senate to remove him from office even if there were enough votes to impeach him in the House.

There are of course other alternatives to using the 14^th Amendment which have been publicly discussed. We can all of course keep speculating what the Administration would do if the Treasury runs out of cash; all the options, including default, look bad. We don’t know, though, and we can all hope that we don’t find out.

What makes the possibility of the debt limit not being increased in time more worrisome than in past episodes is the weakness of the Speaker. In order to pass a debt limit with whatever other language is acceptable to 60 Senators and which the Administration can grudgingly accept, Speaker McCarthy will likely need some votes from House Democrats to offset the loss of votes from some House Republicans. Given that it only takes one member to call for a vote “to vacate the chair,” McCarthy could well lose his position if he chooses to put the debt limit legislation for a vote on the floor.

Of course, in October there could be a government shutdown due to a failure to pass appropriation bills. We’ll get to see how that works out after the debt limit issue is resolved one way or another.

Book Review: “Empire of Pain: the Secret History of the Sackler Dynasty” by Patrick Radden Keefe

 I came to read Empire of Pain not because of any strong interest in learning about the family and the pharmaceutical company which profited greatly and met their downfall from marketing a version of oxycodone, OxyContin, but because of my appreciation of the author. I had read another book by Patrick Radden Keefe, Say Nothing: A True Story of Murder and Memory in Northern Ireland, which I greatly liked and came to the conclusion that any book Mr. Keefe writes is probably worth reading. Both Empire of Pain and Say Nothing are nonfiction but read like novels. Keefe does a prodigious amount of research and then tells a captivating story. In addition to be entertained by the narratives, both books impart a great deal of information in a painless way. In reading Say Nothing, the reader will learn a great deal about sectarian conflict in Northern Ireland, and in reading Empire of Pain, the reader may come away somewhat horrified by pharmaceutical industry marketing practices and political influence.  

Empire of Pain recounts a multi-generational history of the Sacklers. The first part of the book devotes considerable attention to Arthur Sackler, who personally had nothing to do with OxyContin, having died before Purdue Pharma started selling the drug. In fact, his direct descendants did not profit from OxyContin either, since they did not have an ownership interest in the company when it was selling OxyContin. It was Arthur’s two younger brothers and their children and descendants who reaped the benefit.

Keefe’s rationale for focusing on Arthur until his death is that he pioneered the marketing techniques that later were used to sell OxyContin.  Roche had developed two minor tranquilizers to compete with Miltown (derisively referred to as “mother’s little helper”), Librium and Valium. These tranquilizers, especially Valium, became widely prescribed starting in the 1960s, but they can be abused and can lead to dependency or addiction. Of course, they are not as dangerous as opioids.

Arthur Sackler became rich from his company helping Roche to market Valium and then used some of his wealth for philanthropic purposes, especially for art museums. The tale of his business practices, including convincing doctors to prescribe Valium, interactions with the U.S. Food and Drug Administration, and secretly having part ownership of his principal competitor are fascinating to read.

The rest of the book is mainly about OxyContin, which when used as directed, provides time-released oxycondone to relieve pain. It was the main drug that Purdue sold, and the company did nothing to monitor its use, such as certain pharmacies and doctors dispensing and prescribing enormous amounts of the drug. Purdue continued to send their marketing teams to doctors’ offices to convince them of the safety and usefulness of the drug even though they knew it was being abused in dangerous ways. The company blamed those who became addicted on the addicts. 

All of this was a major factor in the opioid addiction crisis. For many years, the Sacklers and Purdue were able to fend off legal challenges from prosecutors concerned about what was happening in their communities. The problems eventually became too much for Purdue and it declared bankruptcy in 2019. None of the Sacklers were prosecuted for crimes. While they left the company, they were able to keep most of their wealth. However, to the extent it matters, the Sackler name was erased at many of the museums and other institutions which had benefitted from Sackler donations.

Keefe’s book is partly an indictment of the Sackler family. For example, he is quite harsh towards the granddaughter of one of the Sackler brothers, who is a documentary film maker. Madeleine Sackler has never had anything to do with Pharma, but of course some of her wealth is likely derived from what she inherited. At a minimum, she should probably be more upfront about that, but does that mean her films are forever tarnished?

The book does forcefully document the ways the legal system can sometimes let the rich get away with crimes. This is indicated in the prologue, which describes Mary Jo White, a former prosecutor who was appointed chair of the SEC by President Obama, assisting one of the Sacklers in a 2019 deposition.

When I read the prologue, I thought this deposition, just as Chekhov’s gun, would resurface at the end of the book. It does not. But Keefe does quote a lawyer as saying, “Everyone is entitled to a lawyer, but it doesn’t have to be you.” That will have to do.

Finally, the book reminds me of the mangled rendition of what Honoré de Balzac once wrote: “Behind every great fortune lies a great crime.” What Balzac actually wrote in Le Père Goriot was: “Le secret des grandes fortunes sans cause apparente est un crime oublié, parce qu'il a été proprement fait.” While this has been translated in various ways, a literal translation is: “The secret of great fortunes without apparent cause is a forgotten crime, because it was properly done.” In this book, Keefe is trying to make sure that the Sackler’s crimes are not forgotten.

The Lexington Column on the U.S. Budget and Debt and Deficits

This will be a brief note on the “Lexington” column in The Economist of February 4, 2023.  The article mainly hammers away at the political dysfunction of the U.S. government budget process: “Both parties have learned that, by luxuriating in polarisation, they can ignore that governing requires trust and compromise. Republicans can have their tax cuts, Democrats can have their spending, and they can blame each other for the debt.”

This is simplistic political analysis. For example, the Trump Administration was not adverse to spending, and deficit reduction has been more of note during Democratic rather than Republican Administrations. Tax cuts have been more characteristic of Republican administrations, but, after a tax cut that went too deep at the beginning of the Reagan Administration, it endeavored to increase revenues. And, parenthetically, I would note that the one of the best tax bills to pass Congress in the last 40 years (or more) was the Tax Reform Act of 1986, which required a bipartisan effort and was set in motion by Republican Treasury Secretaries Donald Regan and James Baker. (Some of its more notable features have since been jettisoned.)

In addition, there is the implied assertion that the current level of the debt is bad or dangerous and that the coming additions to the debt through future deficits is also bad or dangerous. Perhaps this assertion is correct, but the nearest the article comes to making this case is to point out that the debt to GDP ratio is high, that the debt held by the public is $24 trillion, and that the cost of servicing this debt represents 7% of federal outlays and that this will increase as interest rates go up. Numbers meant to be scary are not by themselves a convincing analysis.

Nevertheless, I am happy to note that Lexington did not refer to the headline figure of the debt limit ($31.8 trillion) but rather to debt held by “the public.” In the peculiar way the English language is used by the Treasury, the “public’ excludes government trust funds, such as Social Security, but does include the Federal Reserve Banks, which are technically “private” corporations. If you subtract out from the publicly held public debt the holdings of the Federal Reserve, the resulting number is sometimes referred to as the “privately held” public debt. It’s all very confusing.

For reference, here is my recent post about public debt numbers. A good, objective explanation of the statutory debt limit is in this Pew Research Center article, “5 facts about the U.S. national debt.”

The Debt Limit: A Note on the G Fund and the Exchange Stabilization Fund

The G Fund is one of the funds offered to federal employees as part of the Thrift Savings Plan, the federal employee equivalent to a 401(k) plan.  This fund is invested in one-day non-marketable Treasury securities with an interest rate determined monthly. There is a special provision in the law creating the Thrift Savings Plan that makes the G Fund whole if the Secretary of the Treasury decides to disinvest it entirely or partially due to a debt limit problem once the debt limit issue is resolved. The nonmarketable Treasury securities in the G Fund count against the debt limit, thus, disinvesting the G Fund makes room under the debt limit for the Treasury to issue marketable Treasury securities in order to raise needed cash.

The G Fund is included in intragovernmental accounts. As of the end of December 2022, its assets were $210.9 billion.

The Exchange Stabilization Fund (ESF) is a fund managed by the Secretary of the Treasury. It is primarily used for foreign exchange operations. Here is the Treasury’s brief description of the ESF.

As of November 30, 2022, the ESF had $210.3 billion in assets, of which $17.6 billion were in non-marketable Treasury securities. When the ESF is disinvested because of a debt limit problem, the Treasury does not have the authority to make it whole once the debt limit impasse is resolved.

The Bipartisan Policy Center (BPC) has a description here of what it calls “the big three” extraordinary measures. These are the G Fund, the ESF, and federal employee retirement funds.

Interestingly, Jerome Powell, before he was nominated by President Obama and confirmed to be a governor of the Federal Reserve, worked at BPC. He took a particular interest in debt limit issues, which he knew first hand as an Under Secretary of Treasury for Domestic Finance in the George H. W. Bush Administration. (He was for a time my boss at Treasury.) Probably his efforts at lobbying Republicans in Congress on the debt limit while at BPC during the Obama Administration was a factor in his nomination to the Fed Board.

Debt Limit and Treasury Securities Held by the “Public”

The debt limit reporting in the media is fairly good on the political aspects of the issue, but less good on other relevant aspects.

One issue has to do with the size of the debt. The debt limit is $31.4 trillion and the debt subject to that limit is bumping up against that number. However, reporting I have seen fails to mention that of that $31.4 trillion, about $6.9 trillion is held by intragovernmental accounts, including the Social Security trust funds. The Treasury consequently reports that about $24. 6 trillion is held by “the public.”

However, included in “the public” is the Federal Reserve System. Federal Reserve outright holdings of Treasury securities currently stand at about $5.5 trillion. (The system also reports owning $2.6 trillion of mortgage-backed securities, which they state are “fully collateralized” by Treasury securities.)

Subtracting the $5.5 trillion from $24.6 trillion leaves about $19.1 trillion of “privately-held” debt of the type subject to the limit. This includes foreign holdings, including foreign governments and central banks.

While the Federal Reserve Banks are technically private corporations owned by the member banks, for most analytical purposes they should be considered part of the government. The Fed remits “excess earnings” to the Treasury. Its major expenses are for its operations, interest paid on bank reserves, and interest paid in connection with its open market operations. A major source of income is interest received on Treasury and other securities. (For more on this, see this Fed press release.)

While $19.1 trillion is still a large number, the current reporting misses that close to 40 percent of  the debt subject to limit is debt that the government essentially owes itself or to the Federal Reserve.

A Comment on "A Monetary and Fiscal History of the United States, 1961–2021" by Alan S. Blinder

Prominent economist and former vice chair of the Federal Reserve Board has written an interesting and accessible book on macroeconomic policy from 1961 to 2021. The title is deliberately similar to the tome written by Milton Friedman and Anna Schwartz, A Monetary History of the United States, 1867–1960. Blinder clearly wants to emphasize that fiscal policy matters.

Blinder’s perspective of this history is mostly persuasive, and he effectively argues against Milton Friedman’s simplistic and often quoted statement: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” One of the weaknesses of monetarism as a policy guide is its assumption that velocity is more or less constant in the famous identity, MV=PQ. Monetarism holds much less sway among economists than it did in the 70s and 80s.

While I recommend the book for those interested in the subject from historical, political, or economic perspective, I will focus here on Blinder’s comments about economic policy in the first few years of the Reagan Presidency. I did not find Blinder’s analysis here convincing.

When Reagan entered office, the Federal Reserve under Paul Volcker was pursuing a very tight monetary policy and the economy was suffering from a recession. In the summer of 1981, the Congress passed and Reagan signed The Economic Recovery Tax Act of 1981, which provided large tax cuts. Also, there was a large increase in defense spending, and the federal budget deficit increased dramatically.

In other words, monetary policy was contractionary and fiscal policy was expansionary. As we know, this policy mix eventually worked. Inflation came down and the economy recovered. However, in discussing this episode, Blinder attacks economist Robert Mundell.

Blinder states that “according to the mainstream view, contractionary monetary policy (à la Volcker) raises real interest rates, though perhaps only transitorily, and slows the growth of aggregate demand...[E]xpansionary fiscal policy (à la Reagan) raises real interest rates and speeds up the growth of aggregate demand. Put them both together at the same time, as Reagan and Volcker did, and you should expect real interest rates to rise sharply while the net effect on real output depends on how the tug-of-war just sketched works out.” (p. 143). 

He contrasts this conventional view with what Mundell wrote in a 1971 paper: “Monetary acceleration is not the appropriate starting point from which to initiate the expansion [in 1971], because the risk of igniting inflationary expectations. Tax reduction is the appropriate method. It increases the demand for consumer goods, which reverberates on supply...Because of the idle capacity and unemployment, in many industries increased supply can generated without causing economy-wide increases in costs. Tax reduction is not, therefore, inflationary from the standpoint of the economy as a whole.” (p.144). 

There does not seem to be a huge difference between the two views, but Blinder asserts without much discussion that there is. He views the “Reagan-Volcker policy mix” as “a bold experiment” and asks: “Which side of the policy mix debate came out looking better?” He answer that it is “the conventional side, by a country mile.” To prove that, he discusses an increase in real interest rates (defined as the Treasury ten-year rate minus CPI inflation over the past 12 months) and an increase in the dollar exchange rate. However, he has not provided any information about what Mundell may have said about the effect on real interest rates or exchange rates. 

While one can criticize both the size and the details of Reagan’s enormous tax cuts, the size and details of the increase in defense spending, and the effect on the lives of many people suffering from unemployment at least partly due to monetary policy, it is nonetheless true that the economy recovered and inflation came down. Blinder does not like the argument that Mundell essentially made: the government had two policy goals (ending the recession and reducing inflation) which should be addressed with two different policy instruments (fiscal and monetary policy). Blinder may have good reasons to disagree with using fiscal and monetary policy differently when faced with stagflation, but he does not effectively argue why. 

It is not clear whether Reagan or his economic advisers had developed their economic policy with any formal analysis of the combined effect of a contractionary monetary policy and an expansionary fiscal policy. They may have stumbled into it for polical or ideological reasons. Blinder is surely right that Republicans have since then seemed to think that tax cuts are always the answer to whatever the current economic problem is and are effectively more relaxed about budget deficits after the Reagan experience (no matter their rhetoric arguing for balanced budgets).  

It is disapointing though that Blinder does not have a better analysis of the policy mix in the early Reagan years and whether he thinks that there could have been better policies at the time. A better thought out and explained argument against what Mundell was advocating would have been interesting.     

A Note on Liz Truss, Pension Funds, Financial Markets, and Systemic Risk

The common wisdom is that the financial markets punished Liz Truss and her Chancellor of the Exchequer, Kwasi Kwarteng, for their plan to cut taxes and increase deficit financing. However, Narayana Kocherlakota, a former president of the Federal Reserve Bank of Minneapolis, in a Bloomberg Opinion article (also appearing here in the Washington Post), and others argue that the Bank of England is responsible for the end of the Liz Truss government. Kocherlakota writes: 

The common wisdom is that financial markets “punished” Truss’s government for its fiscal profligacy. But the chastisement was far from universal. Over the three days starting Sept. 23, when the Truss government announced its mini-budget, the pound fell by 2.2% relative to the euro, and the FTSE 100 stock index declined by 2.2% — notable movements, but hardly enough to bring a government to its knees.

The big change came in the price of 30-year UK government bonds, also known as gilts, which experienced a shocking 23% drop. Most of this decline had nothing to do with rational investors revising their beliefs about the UK’s long-run prospects. Rather, it stemmed from financial regulators’ failure to limit leverage in UK pension funds. These funds had bought long-term gilts with borrowed money and entered derivative contracts to the same effect — positions that generated huge collateral demands when prices fell and yields rose. To raise the necessary cash, they had to sell more gilts, creating a doom loop in which declining prices and forced selling compounded one another.

Given this observation, Kocherlakota draws two conclusions about the Bank of England. The first conclusion is that it failed in its regulatory mission and did not do anything about too many pension funds following similar investment strategies that go under the rubric “LDI” (“liability-driven investing”). This failure forced the Bank of England to buy gilts even though it was following a monetary policy of tightening credit conditions. Mr. Kocherlakota makes a good point here.

The second conclusion Kocherlakota makes is more speculative: “[The Bank of England] refused to extend its support beyond Oct. 14 — even though its purchases of long-term government bonds were fully indemnified by the Treasury. It’s hard to see how that decision aligned with the central bank’s financial-stability mandate, and easy to see how it contributed to the government’s demise.” The head of the Bank of England, Andrew Bailey, denies that he was trying to force Liz Truss out.

The Liz Truss government is history, but going forward this aspect of her downfall demonstrates potential problems in financial markets as interest rates increase. The advice that pension funds and other institutional investors receive may not have a full discussion of the risks, and regulators may have difficulty identifying these issues before they become major problems.

In the early 1980s when I was working on financial market issues at the U.S. Treasury, pension funds investing to manage their liabilities for defined benefit plans were generally advised “to immunize” their balance sheet. One way of doing this was to strive to have the same “duration” for their assets as for their liabilities. (Duration is not maturity; rather, in its simplest form, it is an average of the time to each cash flow, including interest payments, weighted by the present value of each payment.) When the durations match, a given change in interest rates will produce offsetting changes equal in magnitude to a pension fund’s assets and liabilities. For example, an increase interest rates will decrease the current value of assets but will also decrease the current value of liabilities by approximately the same amount if the portfolio is immunized.

Apparently, some investment advisers to pension funds have now proposed that defined benefit plans use derivatives so that only part of their assets are used to immunize their liabilities This frees up room for them to invest in assets they believe will achieve higher returns. The problem is that when interest rates increase, they may be subject to margin calls on the derivatives that are in effect long positions in some underlying asset. If the interest rate increase is significant, then the pension funds will need to sell assets to meet the margin calls. If a number of funds need to do this at the same time, this can cause problems, depending on their collective relative size. (For those interested, here is some marketing material for LDI for pension funds.)

As for the implications in the U.S., an article in Pensions & Investments, “U.K.'s LDI-related turmoil puts spotlight on use of derivatives,” indicates that people in the pension industry are thinking about it. I assume that the Financial Stability Oversight Council, chaired by the U.S. Treasury, and its member agencies are also looking at this issue, and, one assumes, that the Labor Department, which has responsibility for pension fund under ERISA, is also looking at it.

Of course, the move by corporations to offer their employees defined contribution plans rather than defined benefit plans means that the share of retirement money that need some sort of immunization strategy has declined. The Pensions & Investments article suggests that the risks of something similar happening in the U.S. to what happened in the UK are not that great, but of course the regulators have access to more complete information, should they choose to ask for it, than do reporters.

While it may be true that LDI, as implemented in the U.S., does not pose a systemic risk in the U.S., though it may be a significant risk to some particular defined benefit plans, there may be other systemic risk issues in the U.S. and internationally as the Federal Reserve increases interest rates. One aspect of the 2008 financial crisis highlights the problem. I remember that even shortly before the crisis hits in full force, many investment professionals were arguing and providing detailed charts in support of their contention that the subprime mortgage market was relatively small and that problems there would not be a big deal. Many probably even believed that.

I hope the U.S. regulators learned from that experience and can put aside their turf issues and their “clientitis” inclinations and examine what dangers may be lurking. The Federal Reserve, to its credit, has made no secret of what it intends to do in the coming months.