US debt ceiling discussions are a predictable feature of the policy-making process. The only uncertainty regarding the Treasury’s ability to continue meeting its cash obligations was timing: would it be July or August? As it turns out, the date is likely to be sometime in June.
Commentary regarding this debate is equally predictable. Indignant pundits point to the apparent dissonance between the approval of the budget and the process of approval for its financing. How can a legislature that agreed on a budget even consider another debate about something they have substantively already decided? How is it possible that politicians argue to the point of taking a country to the brink of default?
These debates are not without consequences. In the past, government shutdowns have inflicted meaningful hardship on Federal employees, contract workers, and their families. In 2011, S&P downgraded US’s credit rating from AAA (outstanding) to AA+ (excellent). This year Fitch has placed its AAA rating on negative watch.
We think, however, that there is some merit to the debt ceiling debates, even if it appears to contradict logic. The existence of this debate marks an opportunity for the Administration and members of Congress to focus their minds on the medium-term fiscal trajectory. Many countries achieve this goal through other means. Germany, for example, has a debt break that limits fiscal room for maneuvering. In Brazil, fiscal rules specify that government expenditures can only rise by a portion of the increase in revenues.
Far from being a nuisance, fiscal rules can be a useful tool in anchoring the medium-term fiscal outlook. From this perspective, having a periodic debate about the debt ceiling can play a similar role to strict fiscal rules without its formulaic automaticity.
There are three solutions being discussed in the media, that would avert a default even if Congress does not agree on a deal to raise the debt ceiling. The first such solution is to circumvent the ceiling altogether by having Treasury issue either Premium Bonds or Consols. Premium bonds can be issued at a Par Value of 100 but carry a very high coupon. Sold at auction, such bonds would fetch a very high price. Suppose Treasury refinances a maturing 10-year Treasury with another 10-year bond that has a coupon of 25%. With current yields at 3.8%, such a bond would fetch a price of about 288. Another possibility is for the Treasury to issue a perpetual bond that has no par value at all. Rather than raising an obligation to pay back something, Treasury can sell rights to an income stream. Suppose the Treasury issues a Consol that pays $100 a year forever. With long-term yields currently around 3.8%, this could be auctioned at around $2650. Because the debt ceiling applies to the amount that the government needs to repay in terms of obligations rather than what they need to pay in terms of debt service, both of these solutions would enable Treasury to raise substantial financing without violating the debt ceiling.
Another solution involves the power of the Treasury to mint commemorative coins in any denomination. Proponents of the “coin” solution argue that Treasury can simply mint a $1 trillion coin, deposit it with the Fed, and start using drawing on its account.
The third solution involves disregarding the debt ceiling and continuing to issue debt on the basis that stopping would trigger a default. This would be a violation of the 14th Amendment of the Constitution, which states: “The validity of the public debt of the United States, authorized by law … shall not be questioned.” Such action would immediately trigger a legal challenge that would quickly end up with the Supreme Court. Proponents of this solution argue that this would put a permanent end to the debt ceiling debates.
All of these solutions may be technically possible but are sorely lacking. They rely on the letter of the law rather than its spirit. We think that action along any of the routes above would do nothing more than deepen political divisions.
Regardless of the rhetorical high drama that is very likely in the days ahead, both Republicans and Democrats understand that the cost of a default far outweighs any political scores they can gain. This was implicit in the past when a lack of agreement led to government shutdowns: recognising the cost of default, policymakers chose to prioritise bondholders over government employees, contractors (and hence voters).
A compromise between the White House and the Republican leadership is thus inevitable. Both sides concede that the compromise will take the form of a cap on the growth of future government spending. The question is by how much. Will it be a 3-year cap as the Biden Administration seems to be putting on the table, or will it be closer to 10-year cap as the Republicans wish to see?
Uncertainty in the run-up to debt ceiling debate invariably raises bond yields. Indeed, the whole of the Treasury yield curve has shifted up in the past two weeks. But the past suggests that yields fall relatively quickly following agreement. In the event of a government shut-down, long duration bonds rally. We see the current environment as an opportunity for investors to increase duration of bond exposure rather than shy away from US Treasuries.
