Failure to reach a deal to raise the U.S. debt limit may force President Barack Obama to choose between paying Chinese bondholders or American soldiers, and between Iowa farmers or elderly Social Security recipients.
Those are among the dilemmas Obama may confront should talks with Republicans founder and the government falls short of funds needed to pay its bills. Other choices would include whether to sell at cut-rate prices financial assets such as gold in Fort Knox or loan portfolios acquired through the bank bailout, to avoid default and keep government services going.
Even if full payments are made to bondholders, interest rates on U.S. debt may still rise, setting off ripples through the financial world that would drive up costs for other borrowers and impede economic growth, said bond traders.
“Stopgap measures such as picking and choosing which programs to support would almost be as bad as default itself,” said Christian Cooper, head of U.S. dollar derivatives trading in New York at Jefferies Group Inc., one of 20 primary dealers that trades with the Federal Reserve.
While House Speaker John Boehner and other Republicans say the U.S. Treasury’s Aug. 2 deadline for when its borrowing authority will reach its limit is artificial, economists and former government officials say those are the types of questions the Obama administration will face if no accord is reached.
“It’s a real deadline,” said Jay Powell, a former Treasury undersecretary for President George H.W. Bush. “Could you live through that for a month? Theoretically, you could. It would be very chaotic. It would hurt the economy.”
Obama Meets Republicans
Obama is scheduled to meet today with congressional leaders from both parties to negotiate an increase in the nation’s $14.3 trillion legal debt ceiling. Obama, who has urged Congress to complete an accord within the next two weeks, is open to a long- term deal to tackle the country’s finances, although he and other Democrats say an agreement must include revenue increases. Boehner of Ohio says any plan that calls for higher taxes wouldn’t pass Congress.
The administration has resisted offering any guidance on how the Treasury Department would respond should the talks fail.
David Plouffe, Obama’s chief political adviser at the White House, dismissed as “inconceivable” the idea that the government would choose between paying investors and soldiers.
“The notion that we would just pay Wall Street bondholders and the Chinese government and not meet our Social Security and veterans’ obligations is insanity, and is not going to happen,” Plouffe said at a Bloomberg Breakfast yesterday.
Yet the Treasury Department says it will exhaust a series of “extraordinary measures” in managing government finances to avoid exceeding the limit on Aug. 2.
And without authority to borrow additional funds, the federal government’s day-to-day income from taxes and other revenue would only cover 56 percent of projected expenses for the remainder of August, according to a study by the Bipartisan Policy Center in Washington, where Powell is a visiting scholar.
Since Congress already has legally obligated all the government spending, Treasury Secretary Timothy Geithner would be left to pick which bills are paid and which are delayed, the Government Accountability Office concluded in 1985.
The Congressional Research Service said in a report last month that one precedent the White House might follow is focusing first on maintaining essential services such as the military, law enforcement and air traffic control as it did in the mid-1990s government shutdowns.
Under one scenario developed by the Bipartisan Policy Center, the federal government would be able to use its projected $172 billion in income to meet its $29 billion in interest payments in August along with Social Security, Medicare and unemployment benefits and payments to defense contractors, if it ceased all other functions. As a consequence, under that scenario, the military and civilian federal workers wouldn’t be paid, IRS refunds wouldn’t go out, and veterans wouldn’t get benefits.
A report by George Mason University’s Mercatus Center cited by some Republican members of Congress estimated the federal government has $2.4 trillion in assets such as gold, currency reserves and loan portfolios that could be sold to private investors to temporarily make up the funding shortfall for months.
Mary J. Miller, assistant Treasury secretary for financial markets, rejected the idea in a May 6 statement as a “fire sale” of financial assets that “would be damaging to the economy, taxpayers, and financial markets."
Better Than Default
Even so, Veronique de Rugy, a senior research fellow at Mercatus and co-author of the report, said asset sales would be preferable to the consequences of a default that the Obama administration holds out as the inevitable result of failure to meet the deadline. She cites a rush sale of equity investments held by the Treasury Department’s Troubled Asset Relief Program that Mercatus valued at $142.5 billion as of Sept. 30, 2010.
“Let’s say people who would buy these assets know we are in a hurry and play hardball, maybe give us $50 billion. Well, better than defaulting,” de Rugy said.
Some Democrats in Congress also have discussed the idea of claiming presidential authority to continue borrowing without congressional approval based on an interpretation of the Constitution’s 14th Amendment. A provision originally passed to prevent Southern sympathizers from later repudiating the federal government’s Civil War debt declares the “validity” of U.S. government debt “shall not be questioned.”
Senator Charles Schumer of New York, the chamber’s third- ranking Democrat, told reporters last week the issue is “worth exploring,” though “you wouldn’t want to just go ahead and issue the debt and then have one of the courts reverse it."
Worse Than Cure
Cooper, of the Jefferies Group, said either issuing debt under such an untested legal theory or financing the government with unusual asset sales would risk raising investor anxiety and increasing interest rates.
“Taking that extra step of asset sales would send such a negative signal to the marketplace, that the U.S. is having to engage in Greece-style asset sales to raise money to pay obligations, that the medicine is worse than the cure,” he said.
Yields on 10-year Treasury notes yesterday fell one basis point, or 0.01 percentage point, to 3.11 percent at 5:05 p.m. in New York, according to Bloomberg Bond Trader prices.
“There doesn’t appear to be great concerns in the market yet,” said Paul Kasriel, chief economist at Northern Trust Corp. in Chicago.
If the U.S. misses a payment on its debt, Standard & Poor’s would cut its credit rating from its sovereign top-level AAA ranking to D, the last rung on its scale, said John Chambers, chairman of the company’s sovereign rating committee.
“If any government doesn’t pay its debt on time, the rating of that government goes to D,” Chambers said June 30 in an interview on Bloomberg Television.
Even a temporary default by the U.S. would likely have “large systemic effects” on the economy and Treasury finances by disrupting money funds, the repurchase-agreement market and foreign investor willingness buy the government’s debt, JPMorgan Chase & Co. said in a report.
Ten-year Treasury yields may rise about 37 basis points if the U.S. government temporarily misses a debt payment while promising to make bondholders whole as soon as the debt limit was raised, according to a mean estimate of 45 JPMorgan clients that were surveyed by the firm. Foreign investors forecast yields would rise 55 basis points/
An increase in Treasury yields of 50 basis points would reduce U.S. economic growth by about 0.4 percentage points, JPMorgan said, citing Federal Reserve research and data.
“If we get into the last week of July or the first week of August and the debt ceiling hasn’t been raised, the markets will begin to react,” said Terry Belton, global head of fixed-income and foreign-exchange research in Chicago at JPMorgan Chase, a primary dealer that trades with the Fed. “The biggest risk in our mind has been and continues to be the threat of damaging foreign sponsorship of Treasuries.”
If the longer-term U.S. rating was cut one step to AA+ from AAA, stemming from political “deadlock” and concern over a lack of long-term “fiscal policy reform,” JPMorgan estimates Treasury yields would rise about 100 basis points.
A downgrade or default may affect the repo market, reducing the percentage of par Treasury value accepted for collateral to 98.5 percent, the average during the financial crisis, from about 99.5 percent, JPMorgan said. About $4 trillion of Treasuries are used as collateral in the market for repos, which are used by securities dealers to finance holdings and increase leverage, the firm said.
A “sharp” devaluation of Treasuries for use as collateral may lead to “significant margin calls, some forced de-leveraging and a decline in lending capacity in financial markets,” JPMorgan said.