I: A NASTY GAME OF CHICKEN
Well, we’re in one hell of a pickle now. On 19 January, Janet Yellen announced that the Treasury had maxed out its credit, run afoul of the $31.381 trillion debt ceiling and was resorting to “extraordinary measures” to keep paying its bills. This is what US Treasuries secretaries say when the government starts deferring investment in future pensions to conserve the cash with witch to pay the monthly bills. And what regular people do to keep the lights on when the balloon-payment on that ill-advised Mercedes shows up.
The next day, the Biden’s Press Secretary said in a statement: “Raising the debt ceiling is not a negotiation; it is an obligation of the country and its leaders to avoid economic chaos.”
Ms. Yellen reckons that said chaos can be avoided until about July, which we’re now calling “X-date.” Which if the past is anything to go by, will involve a theatrical shut-down of non-essential government services. Non-essentials are tricky to define: I know what the guy from animal control does all day. I’m just not so sure about my congressman.
With due respect to the Biden administration, it really is not the job of congress to pass out the fun stuff every time the president wants to buy a vote. Certainly not if we can’t pay our bills. The GOP position is that congress will not to raise the debt ceiling without some spending cuts. This is the only position that makes any practical sense. The problem is that, at the moment, the GOP doesn’t make any practical sense.
So why, you well may ask, are the Democrats so confident in their position – namely to simply not negotiate? Because in 2011, the last time we faced a default under President Obama, the Republicans blinked at the last minute and they are betting that they will again
If you are not the president or a member of congress, and are therefore forced to do something constructive with your life, all of this is alarming. Contemplating the unthinkable generally is. With two sides refusing to negotiate, and the sinister sounding X-date approaching, some political workarounds are being tossed around and vary wildly in their badness:
We’ll call the first options “The Magic Penny” because it is more absurdist theater than serious option. Or so I thought until some progressive Democrats and sages on social media started promoting the solution under the hashtag #MintTheCoin. The wheeze involves having the Treasury strike a platinum coin – which technically, it does have the power to do – in a $1 trillion denomination. Then, deposit said coin with the Federal Reserve, which would then credit the Treasury’s account. Presto, another trillion dollars to play with. In short, print money. Can you say “Memories of Weimar?”
It would be lovely if currencies actually worked that way. Like any other commodity, the value of money is reckoned by the market – what people believe it is worth - rather than what is stamped on it. Zimbabwe famously printed heaps of cash and had more billionaires than any other country on the planet. Which bought you a big cup of coffee.
The scheme also has a whiff of crypto-thinking: Just conjure up a coin with a suspiciously self-serving valuation and hope the public buys the story. Printing money gave us Weimar Germany and Boris Yeltsin’s Russia, the scary part is that Weimar Germany gave us Adolf Hitler and Yeltsin’s Russia gave us Vladimir Putin. So, avoiding the magic thinking of the first option, let’s move on to something a little less fraught.
II. God, The Universe and Bonds
It doesn’t get the attention, but the bond market is several times larger than the famously fussy stock market. The bond market is huge and largely responsible for nearly all the infrastructure that we take for granted. Anything that large is stable. Bonds are a fundamentally simple instrument, but acts counter-intuitively. It’s like our concept of God, who we like to keep to a short chat on Sundays and not fiddling about with our portfolios. Most of us have too many unanswered prayers to take that sort of risk. Treasuries even have its high priest, although, like a lot of congregations, Mr. Powell’s isn’t convinced he knows what he’s talking about, and keeps betting against him.
Still we need debt instruments, not just for our infrastructure, but to keep our republic bumping happily along. Tax revenue covers only about four fifths of government spending. That last 20% is on credit which the government finances through the bond market; read borrowing money from everyone and paying it back later. It’s a lot less politically painful that raising taxes. Of course, like any credit, the vig has to be paid and the way you do that is to raise taxes. But that’s the next guy’s problem.
Without the ability to issue bonds, that fifth of government has to stop, which would yank about 5% of GDP out of the economy overnight. And that would create a very immediate problem that we couldn’t kick down the road the next guy. In the event of a US default, stocks would plunge; interest rates would skyrocket and getting it under control would not be a matter of Mr. Powell bringing it up and the next Fed meeting. Economic growth would crater here and abroad.
So it’s with that in mind that we approach Option Two: The Ultra-High Rate Bond. It’s less silly than the magic penny, and like a lot of bad ideas, it looks pretty simple on paper. The trick is to float a trillion dollar’s worth of one-year bonds with an astronomically high coupon 105%, and sell them for twice their face value. This would result in a yield to investors of 5%, the current prevailing rate. Since only the face value of a bond counts towards the debt ceiling, the Treasury will have raised $2trn (from selling it a two times the face value) while only adding $1trn to the national debt (the face value).
On reflection, this seems like the sort of thing they get up to in Greece.
The most glaring problem is that this maneuver is such an obvious shell-game: like paying off the Visa with a Mastercard. US Treasuries function the way that they do because they are perceived to be risk free. True, most finance is a shell-game, but an outfit pulling a stunt like that with your money, is hardly risk-free. It also runs afoul of British economist Walter Bagehot’s famous dictum: “Every banker knows that if he has to prove he is worthy of credit, in fact his credit is gone.”
The next hiccup is that the government has already hit the debt ceiling and it will literally – not figuratively – take an act of a very prickly congress to issue another trillion in debt.
II: THE DEFIANCE BOND
The third option for dealing with the debt ceiling – other than actually dealing with it - is largely legalistic. It would a practical disaster, but have the effect of putting that prickly congress in its place. Nor it is entirely without precedent. The 14th Amendment says that America’s public debt “should not be questioned.” Therefore, the thinking runs, that the Treasury can go ahead and issue the bonds it needs in defiance of the debt ceiling because the resulting debt can’t be questioned.
It’s not like we haven’t tried something like this before, in 1775 the Second Continental Congress created a paper money called a “Continental”, then passed a law making it illegal to refuse the new currency. Unlike new bond issues, this was based on gold, rather than “the full faith and credit” of the government. Of course, the government lied about how much gold they, printed way too many notes and gave birth to the phrase “not worth a continental.” This wasn’t because Americans were financial boobs. Well, we were, but no more so that the rest of Europe.
In 1716, a Scotsman named John Law helped create the Banque Royal in France, which issued notes backed by the future profits on a lovely colonial sinkhole called Louisiana. While the government was lying about profits the notes were wildly popular. Until they weren’t. Government finances collapsed when it became obvious that New Orleans wasn’t as profitable as advertised. Some would argue that it still isn’t.
The Swedes had pioneered European judiciary currency using large copper plates. Then in 1656 they switched to printing the more convenient paper bills. The change was physical as well as philosophical. The Stockholm Banco printed heaps of notes until the government collapsed.
A careful reader might detect a pattern here.
The Treasury issuing bonds in defiance of the debt ceiling, under cover of a constitutional amendment would snip elected representative’s power to control spending. Leaving the public to face the meat-hook reality that inflation would be pretty much uncontrollable. Just ask all those Zimbabwean billionaires.
A legalistic workaround would be challenged and almost certainly going wind up before the Supreme Court. We do not want to open that can of worms because one of two bad things would happen: The court sides with defiance of the debt ceiling, the whole nature of state representation gets trampled along with pulling the pin on a large economic grenade.
Or the court sides with congress we have an army of investors holding illegitimate bonds? Do make holders of defiance bonds whole and risk the repeating drama again in a decade. Or cancel the bonds… which looks a lot like default.
The fundamental problem with all these workarounds is that they money, and not its value. The Spanish Empire’s lust for gold absolutely baffled the South Americans, who thought it was pretty, but practically pretty useless. Which it was until everyone agreed that it wasn’t. What Washington doesn’t seem to get is that a government can pass a law giving a currency a denomination, but not its value.
If you are going to have money as a means for exchange the market will seek, or create, a standard exchange mechanism for value. The world got off the gold standard because the dollar became that new standard because it was the obvious choice. Most of the world sees this de facto standard somewhere on the spectrum of resentment – from mere sneering, like the Euro, to subversion, like Beijing’s Yuan – but it is the standard.
So not only will a US default crater the US economy it will have global implications as the world would start looking for another reserve currency after 70 years. Places like China would scramble to fill the void and start dictating terms.
In short, Washington can’t deny the reality of the market forever. An ugly negotiation must be had now, or a much uglier one later. Any of these easy terrible workarounds to the problem will send shockwaves through the market. It is not that America doesn’t have the corps of adults to sort this out like, say, adults.
They just aren’t in Washington.