The New York Times recently had an article about growing Wall Street concern over the possibility that the statutory borrowing limit will not be raised by October 17. Stan Collender, an expert on congressional budget processes, now places the probability of failure to increase the borrowing limit at 25 percent. Short-term Treasury bills are now starting to trade with a risk premium. It might be useful, therefore, for me to offer a brief tutorial on what could happen if the debt limit is not increased.
Government cash inflow comes in essentially two forms: tax receipts and borrowed funds (via sale of Treasury securities). There are also various kinds of user fees, as well as some interest on treasury securities held in trust funds, but these are second order in comparison to taxes and debt. Government cash outflow takes the form, among other things, of payments to contractors, payments for goods and services, reimbursements for food stamps, payments to those on public assistance programs such as TANF or SSI, payments for the big social insurance programs as Social Security OASI and disability, reimbursements to Medicare providers, payments to workers (though these have been suspended due to the shutdown), tax refunds, and interest payments on existing debt. Right now, roughly 70–75 percent of inflows are financed by tax receipts and 25–30 percent by debt.
Now, if the borrowing limit is not raised, you might say that there is a simple solution: cut government spending by 25–30 percent. You may hear that talking point in the days ahead from those who are opposed to raising the debt limit. Putting aside that:
(a) such a huge cut in government spending would send the economy into a recession;
(b) it would essentially wipe out much of discretionary nondefense spending;
it’s not nearly as easy as this, and indeed raises some profoundly difficult questions, with no good answers.
On a given day, say, October 21, there might be $10 billion of tax revenue coming into the Treasury, but $30 billion of payments due because of spending the government has already committed to. Suppose (hypothetically) the payments due consist of $8 billion in interest, $10 billion in Medicare reimbursements to doctors, $10 billion in payments to government contractors for services already rendered, and $2 billion in payments to stores that have accepted Food Stamps. What does the Treasury do? It won’t have enough cash to pay all the bills. Even if the U.S. paid its bondholders and did not “default” on the debt in the sense most people use that term, the U.S. would be in what is called “technical default” because some parties who are owed money by the government won’t be paid on time. So what do you do?
• Prioritize? Pay interest first, partly pay Medicare providers, and don’t pay the contractors or stores that need to have money deposited in their bank accounts for accepting Food Stamps? It’s not clear that the government’s IT system, which processes millions of payments daily, has the capability to do this. Plus, on what grounds do you prioritize? All of these are parties who are legally owed money by the U.S. government.
• Do you defer payments, and wait until you have enough cash on hand? In other words, do you wait a few days until the inflow of additional tax revenue provides the Treasury with $30 billion in cash and then pay all parties who were owed money on October 21 at the same time (perhaps on October 23)? Of course, parties who are owed money on October 22 and 23 would then have to wait for their payments. The “defer payments” option is actually a form of borrowing from parties with an account receivable from the federal government. For example, the Medicare provider is basically being asked to let the government hang onto the money that the provider is owed for a few days so that the Treasury can replenish its working capital to pay all the bills due on October 21. According to the Bipartisan Policy Center, during the last debate over raising the borrowing limit in 2011, senior Treasury officials concluded that deferring payments would have been less disruptive than prioritization.
Still, it is easy to imagine that as long as revenue inflows are less than spending commitments, this approach could only work for so long before the length of the deferral period grew to unacceptable levels. Moreover, what happens on November 1 when the government must pay close to $70 billion to Social Security recipients and military personnel? Is the government prepared to defer payments to troops and Social Security recipients? Will deferrals be prioritized? Beyond all this, deferral is not sustainable without consequences. Would you, as a store owner, continue to accept Food Stamps if it was not clear when you would be reimbursed should recipients use their SNAP debit cards? Maybe Walmart would be willing to do this, but perhaps many local store wouldn’t, which means some SNAP recipients might be unable to use their Food Stamps.
• Do you issue IOUs? This is also borrowing via the back door. Maybe this could work, but the very fact they have to be issued reveals these IOUs to be a risky form of debt, and it’s not clear that recipients would be able to monetize them, or use them as collateral. (Will your local bank accept them as a cash equivalent?) This might be a temporary fix, but it would be costly. It might also be challenged as a breach of the statutory borrowing limit.
• Does President Obama issue an executive order and allow debt to be issued beyond October 17? There is a political ramification to this—he’d probably be impeached—and like IOUs, this debt would be considered risky and might not be usable as collateral in the repo market, potentially freezing up the shadow banking system. The same scenario would unfold if the President invoked the 14th amendment.
There are, I think, no good alternatives, no rabbits that can be pulled out of hats, if the statutory borrowing limit is not raised. Heretofore riskless federal debt—the world’s reserve currency—will become risky (perhaps even after the fever subsides) and the uncertainty faced by the financial markets and real economy will be substantial. The interest rate implications are significant for all the obvious reasons (e.g., mortgage rates will go up, threatening the nascent housing recovery). In addition, it may be that important parts of the economy stop accepting government business—that some doctors, for instance, temporarily or even permanently stop seeing Medicaid patients or, as noted above, some grocery stores stop accepting Food Stamps.
With all of this in mind, we can only hope that Congress will find a way forward in the next few days to raise the borrowing limit.