I’ve spent a lot of time in the last few weeks talking to investors trying to ease concerns over the debt ceiling and default. This piece will provide a brief description of how I view all of this, the potential scenarios and why I think you shouldn’t panic over the debt ceiling politics.
I’ve explained the ridiculous nature of the debt “ceiling” before, but here’s a review:
- Congress establishes a “debt ceiling”, a fake upper limit on how much national debt we can issue.
- Then Congress approves legislation that will require new debt in the future.
- That new legislation necessarily causes a breach of the debt ceiling at some point in the future.
- Congress then forgets that they passed legislation requiring new debt and they refuse to pass legislation raising the debt limit.
- Members of Congress spend a few weeks grandstanding and pretending to care about fiscal responsibility.
- Then the debt ceiling gets raised because we all know defaulting would be the stupidest self inflicted economic wound of all time.
- Rinse, wash, repeat.
This is obviously a ridiculous sequence of events. I’ve compared it to eating a huge meal and then tying a knot in your stomach and then threatening yourself with death if your stomach digests the food. This is crazy. You don’t impose a limit on how much food you eat AFTER you eat the food. The time for fiscal and dietary responsibility is BEFORE you eat.
Ignoring the operational irrationality of this “limit”, let’s discuss actual default potential.
US government bonds, notes and T-Bills are the backbone of the entire global financial system. You might not even realize it, but if you have a brokerage account with a money market fund, bond fund or savings account you probably hold government bills, notes or bonds. If we actually allowed a sustained credit event to occur there would be mass mayhem. There was mass mayhem when the $62 billion dollar Reserve Primary Fund broke the buck in 2008. This is larger by tens of trillions of dollars. And a self inflicted wound of this type is unimaginable. It’s beyond irrational. But let’s entertain this scenario for the sake of understanding.
First, I don’t even think you get to the crisis scenario because the Treasury, President and Fed have tools to work around this and I think they’d be obligated to use these tools. For instance, let’s say we get to May 31st and the Treasury announces it has no money on June 1st. Meanwhile Congress can’t agree on anything. In this case the President is forced to invoke the 14th Amendment on May 31st to uphold the “full faith and credit of the USA”. Once we are on the verge of defaulting we’re breaching the 14th amendment, which states that it’s illegal to default. And regardless of the interpretation of these laws there are many ways to fund the Treasury without Congressional approval. This could include issuing premium bonds, coin seigniorage, selling Treasury assets or the Fed invoking the Exigent Circumstances clause of the Federal Reserve Act to directly (or indirectly) fund the Treasury.1 I am virtually certain that one or all of these would be utilized to avoid an actual default. I am not even remotely uncertain about it. It would be irresponsible and probably illegal for one or all of the above NOT to be implemented. So once we’re on the verge of breaking the law I’d assume that anything and everything is on the table.
But let’s be crazy and entertain the implausible scenario where none of the above is invoked. What would happen would be mayhem. Treasury bonds would be instantly hyper volatile. The stock market probably falls 10%+. A brief panic starts to ensue. In this case Congress either responds quickly because nothing gets Congressional attention like members of Congress losing their own money. And/or the Fed responds with a massive bazooka. The instability in the interest rate market would force them to intervene to stabilize markets. In either case markets almost certainly bounce back quickly to where they were before and then we all look around at each other and say “wow, that was stupid, let’s never do that again”.
These scenarios are why I find all of this so implausible. There’a razor thin chance that the US government defaults, no leader responds at all and it becomes a major structural credit event. We’re not just talking about political theater here and grandstanding. We’re talking about the biggest credit crisis that the world has ever seen. Are we really going to let that happen just because Republicans and Democrats don’t like each other? Maybe my faith is misplaced, but I think we’re all better than that. And at a minimum, if we’re not better than that then the adults in the Fed and Treasury will realize that despite what the children in Congress say and do, adults have a legal and moral obligation to stand up and act responsibly to defend the full faith and credit of the US government.
The bottom line is that the Fed and Treasury have other options and if they’re forced to break laws or invoke questionable workarounds I think they absolutely will. But more importantly, Congress needs to understand that they cannot allow it to even get to that point.
NB – It’s my personal view that the debt ceiling has become weaponized in a manner that is irrational and dangerous. If I were a member of Congress I’d demand that any future debt ceiling increase include a bill to repeal the debt ceiling. There are good times to reduce spending and those times are before we pass legislation that requires funding.
1 – My preferred approach would be the Fed. If I were the President I would walk into Jerome Powell’s office on May 31st and I would order him to fund the Treasury either directly or indirectly using Primary Dealers. I understand this would be highly controversial, but the Central Bank of the USA was created in large part to ensure that the US economy (and government) always has liquidity. This seems like the exact right use case for this scenario regardless of what current law says. After all, once we’re breaking laws we might as well break less bad laws to break a really bad law.2
2 – This scenario also has the useful upside of exposing the charade around how the US government borrows money from the private sector since it literally has its own bank which it can borrow from. We have a government that can literally create its own money without having to borrow from the private sector yet we continue to act like we couldn’t just borrow money directly from the Central Bank or create money directly.3
3 – A footnote inside a footnote inside a footnote. That’s a first. I can hear people screaming about this idea. Yes, it’s true. A national government could theoretically do away completely with issuing bonds and simply print cash when it spends. In fact, we already fund a lot of that spending by issuing T-Bills, which are money. So even under the current system we already fund spending with “money”. If we funded all of it with “borrowed” T-Bills or literally credited deposits into accounts there would be no meaningful difference between that system and the current one. People will scream “debt monetization”, but government T-Bills are already monetized and all government deficits should be considered money issuance in the first place regardless of how we label those assets.4
4 – Okay, this is getting out of control. But to be clear – the limit on this would be inflation and demand for that money from the private sector. Having a printing press doesn’t mean you have unlimited money issuing capabilities. Government deficits can and do often cause big time inflation. We know that coming out of Covid and it was one reason why I vocally warning about inflation in 2021. So I am absolutely not making an excuse for large deficits. I am just explaining some of the nuance in the plumbing of the monetary system. I promise, no more footnotes. Have a great weekend.