By Jay Powell, BPC Visiting Scholar and former Under Secretary of the Treasury for Finance
Watch Powell’s appearance on Fox Business here.
As the 2011 continuing resolution fades into memory, it is time to focus on the second of the three Himalayan peaks that must be climbed this year – the upcoming debt limit vote. The third is the 2012 budget.
Secretary Geithner wrote in his letter of April 4 that Treasury will hit the legal borrowing limit of $14.294 trillion no later than May 16. At that point, Treasury will be unable to borrow in a way that increases outstanding debt. Nonetheless, Congress has ordered the federal government to continue to spend an average of $125 billion per month more than it takes in.
As it has done in past debt limit standoffs, once it hits the debt limit Treasury will resort to “extraordinary measures” to generate cash without increasing borrowings. Four such measures are available, totaling $230 billion. Over $200 billion of that amount is produced by the act of not investing federal employee retirement trust funds in Treasury securities, or by redeeming the securities if such investments have already been made. In either case, the securities are not outstanding, and Treasury thereby acquires room to issue that amount of additional securities to the public, generating new cash. By law, the federal employees are made whole for lost interest once the debt limit is raised.
The $230 billion will cover our deficits for only about 8 weeks, or until July 8 if we hit the debt limit on May 16. Beyond that point, the federal government would be unable to meet all of its obligations for the first time in our history. This would be uncharted and very dangerous territory to enter.
The government’s practice is to pay all of its bills when they are due. There is no federal statute that either requires or explicitly allows the government to prioritize some payments over others. Nor is there a system in place that would cause that to happen in a reasonable and transparent manner. If the government reached the point at which it could not borrow and did not have the cash to pay all of its bills, the result could be chaotic.
If we do get to that point, it is likely to be a short and painful experiment. With a shortfall of $125 billion per month, a lot of really important bills will go unpaid. Over 80% of federal spending is in the big entitlements plus defense and interest, so the cuts will be huge and painful.
It is true, as some have argued, that the government would not immediately default on its funded debt. A Treasury Secretary would rather skip any other payment rather than default on a bond payment. Even so, the spectacle of the U.S Government failing to pay its bills would cause lasting damage to our image around the world.
Even without a bond default, there could be serious repercussions both in the economy and in the financial markets. A drop in government spending of that magnitude would certainly be a harsh jolt to the economy. And it is possible that global investors would be shaken by the turmoil and stay away from Treasuries for a while. The combined effects could be grave. These are risks we would be crazy to run.
Secretary Geithner expressed high confidence on Fox Business today that the debt limit would be increased well in advance of July 8. He said twice during the interview that he has been “spending a lot of time talking to Republicans on the Hill”, and based his optimistic assessment on that. Just “don’t take us too far into June”, he urged.
Perhaps the experience gained in the battle over the 2011 continuing resolution has opened some eyes as to what it would mean to cut federal spending overnight by $125 billion per month. If so, Secretary Geithner’s optimism may be justified, and his time on the Hill well spent. An actual bond default is unthinkable and unlikely. Even a very short term default would cause permanent damage, as is shown by this recent research note from JP Morgan.