Fire, fury and the national debt limit

“We lowered our rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term [budget] progress … will remain a contentious and fitful process.” S&P Global Ratings August 5, 2011.

During the 2016 campaign, then-candidate Donald Trump discussed his broad experience with debt. He would bring the skills and sensibilities of a real estate mogul to government debt management, and the result would be a better deal for the American public. He even broached the idea of renegotiating the obligations of the U.S. Treasury.

Well, the day of reckoning has arrived. The Treasury has announced that by the end of September, it will face a shortfall. Without the authority to issue additional debt, the government will not be able to pay all of its bills—including the interest on the outstanding debt. In response, President Trump has threatened the Congress: either fund the wall along the Mexican border, or he will shut down the government.

If the U.S. government fails to meet its obligations for any significant period, we will all be big losers. A government that cares about the people—both now and in the future—would never willingly inflict such a wound.

Before proceeding, we need to distinguish two issues that tend to get conflated. These are: (1) the prospects for a government shutdown; and (2) the possibility of default on the U.S. Treasury’s outstanding debt. The first of these is bad, as it means suspending the pay of employees and not providing services for those relying on the government. But shutdowns have happened four times since 1990, most recently in 2013. They can be politically damaging, but the economic fallout has been both modest and temporary (see here.)

Default is a completely different story. It would mean that the government does not make at least some promised payments on time. Lacking precedent, it is hard to anticipate the exact consequences. Would Social Security recipients fail to receive their monthly payments? What about government employees’ wages, including members of the military? How about government suppliers? Then there are the holders of Treasury bonds. Will they receive their interest payments? Their principal?

What we do know is that people are getting very worried. According to a recent Wall Street Journal economists’ poll, there is a 17% chance that the government will soon default. Given the fiscal health of the United States, this probability should be zero. Put differently, a voluntary federal default would be dangerously self-destructive. Here are a few reasons.

Let’s start with a straightforward analogy. The default of a fiscally sound government is exactly the same as a wealthy person, replete with financial resources, refusing to pay their credit card bill. There would be serious consequences. The most important is that the shirker’s credit score would plummet. In the case of the government, the choice to default—and it is a choice—would drive up the interest rate on current and future debt.

How much higher? Suppose that the willingness to toy with default risk led to a one-notch credit downgrade of federal debt (as the opening citation indicates, something like this happened to the S&P rating of U.S. long-term debt in 2011). Our NYU Stern friend and colleague, Aswath Damodaran, estimates that a persistent one-notch downgrade (from AAA to Aa1 on the Moody’s ratings scale) is associated with an increased risk premium of nearly one-half of one percentage point.

The consequence of such a downgrade would be two-fold, one immediate and the other over the long run. The first is that current holders of the roughly $15 trillion in Treasury debt would suffer losses. Given the maturity structure of the debt, we figure that a one-notch downgrade would lower the prices of outstanding bonds by something like 2 percent, resulting in a $300-billion loss. Such a bond market thrashing would surely have a long-term impact on the willingness of investors to purchase what today is the world’s safest, most liquid and most widely held financial asset in the world.

The second thing that would happen is that the U.S. Government would have to pay more to borrow for a long time to come. Assuming the level of debt remains roughly where it is now, at 80 percent of GDP, an interest-rate increase of 0.5 percent across the entire yield curve taxpayers would bear an increase in interest expenses of 0.4 percent of GDP per year! Since the bulk of tax revenue comes from people in the middle of the income distribution who have only modest net worth, the result is a transfer to the wealthy. In other words, making government operations more costly in this way also would further exacerbate income and wealth inequality.

Default also risks undermining what has been called America’s “exorbitant privilege.” As we discussed in an early post on this same topic, one reason that the United States is able to finance debt at a lower interest rate is the extraordinary demand for the U.S. dollar as a reserve currency. Foreign governments, businesses and investors use dollars for a wide range of activities. This external demand for dollar assets allows the United States to spend more than it produces (that is, to run a current account deficit) for an extended period without weakening the dollar. As a result, U.S. Treasury securities hold a unique position in the global financial system—a position that default would undermine.

In addition to boosting the risk premium, a loss of confidence in Treasury debt would reduce the demand for dollars, driving the currency’s value lower. Most economists would treat such a deterioration of the U.S. terms of trade as a loss of welfare for U.S. consumers.

This brings us to the next consequence of U.S. Government default: the implications for global financial markets. It is not difficult to imagine a global financial crisis, if the world’s safest asset loses its “default-free” character, and investors rush to find an alternative. A shortage of global safe assets would impose strains on global bond and equity markets, likely slowing economic growth, and possibly triggering a recession.

In sum, the immediate costs of default are large and the long-term risks even larger. Not only that, but this would be a disaster that is entirely avoidable. Instead of counterproductive threats and bluster, we should be looking for institutional changes that prevent even the possibility of any future self-inflicted debt crisis. The goal, in our view, should be a set of fiscal arrangements that impose long-term budget discipline, while allowing short-term flexibility. Higher risk premia, which make borrowing more expensive, do provide such discipline, but at a cost that is completely unnecessary.

Balanced-budget rules are, in our view, another bad solution. Simple rules impose arbitrary restraint in the short run, forcing spending to fall as revenue falls, exacerbating rather than smoothing cyclical fluctuations. In fact, as Auerbach and Gorodnichenko describe (and Furman discusses), austerity in a downturn may do more harm than good (see here, here and here). Balanced-budget rules also typically ignore unfunded commitments for future expenditures and contingent liabilities. More complex fiscal rules that allow for cyclical flexibility can be difficult to enforce and may lack credibility. This is especially true if, as we have recently experienced, long-term growth projections prove too rosy. All in all, imposing a balanced-budget rule seems like a very poor solution to the problem created by the need to raise the debt ceiling periodically in order to avoid shooting yourself in the foot.

We see two straightforward, practical alternatives that Congress could readily implement.

Over the past quarter century, the federal debt limit has been raised on average nearly once a year. In other words, debt limit increases happened at roughly the same frequency as the passage of federal budgets. But, they are done separately. That is, when the Congress passes a budget authorizing expenditure, it does not simultaneously provide a way to pay the bills. Knowing that tax revenue will fall short of the total needed to pay for the year’s spending, wouldn’t it make more sense to simply give the Treasury the authority to borrow up to the limit needed to meet the obligations that have already been agreed?

Suppose, however, that legislators view this simple approach as lacking sufficient fiscal discipline. As an alternative, Congress could prescribe rules for payment priority when the debt limit bites. Some states already do so. For example, in California, the state is obligated to pay first for education, and then to service its general obligation bonds before satisfying other claims. Payment prioritization would be more difficult for the Federal Government. To give some sense of the problem, in the current fiscal year ending September 30, 2017, total expenditure is $4.1 trillion. Of this, mandatory programs—including Social Security, Medicare, Medicaid, and interest on the debt—account for $2.9 trillion. Half of the remaining $1.2 trillion is defense. This leaves $600 billion in non-defense discretionary spending—which roughly matches the budget deficit.

That said, it is clearly possible for the Congress to decide who is paid first, second, and so on. This would have the added advantage that those lower on the list would want to limit increases in the claims of those higher up in the payment rankings. And, assuming that debt-related expenses are on the top of the list, no one will want to see defaults that raise funding costs. This, it seems to us, creates exactly the right incentives for long-run budget discipline.

To state the obvious, the United States Government is not Trump Entertainment Resorts, or any other private firm that could seek bankruptcy protection. When a private citizen threatens default on loans in the course of negotiating with his creditors, the game is zero sum. When President Trump makes threats to Congress that would result in default of the U.S. Treasury, the risk is that everyone will lose.

The nicest thing to say about such threats is that they are irresponsible. That is why no previous President has ever played this destructive game.