Dancing with the debt ceiling

BERKELEY — In 2011, when still vice chair of the US Federal Reserve, Janet Yellen reassured her colleagues that drama around the federal government’s debt ceiling “usually turns out to be just theatre”. Theatre of the absurd, one might add. A decade later, the debt-ceiling debate is shaping up as a tragedy for the ages.

To understand the absurdity of the debt ceiling, recall its origins. The statute creating it was adopted in September 1917, in conjunction with an act authorising the issuance of bonds to help finance US entry into World War I. It was designed to assure opponents of US involvement in the war that there were limits on how far the country would go.

The Constitution had given Congress the power to micromanage borrowing by the Treasury, something that was impractical in wartime. So legislators now delegated this power to the president. But to placate those who opposed any enlargement of executive powers, as well as German-Americans who opposed going to war with Germany and Irish-Americans opposed to allying with Britain after that country’s violent suppression of the 1916 Easter Rising for an independent Ireland, Congress placed a ceiling on that borrowing.

Those all-but-forgotten grievances from more than a century ago created the dilemma the United States faces today. Absurd is right.

Until now, Congress has always succeeded in averting the worst. Even in 2013, a year of partisan rancor, Democrats and Republicans agreed to suspend the debt ceiling just a week before the Treasury, already unable to borrow, ran out of cash reserves. But this year might be different.

Most obviously, political polarisation is even greater than it was in 2013. Norms of political behaviour, including the idea that the two parties should collaborate to avoid a predictable disaster, have gone out the window since the January 6 attack on the US Capitol by supporters of then-President Donald Trump. In a post-fact world, Republican members of Congress, even if they are the actual agents of the calamity, can successfully blame, at least in the eyes of the Republican base, Democratic legislators and their free-spending ways.

The immediate consequence of a failure to raise or suspend the debt ceiling would be a government credit-rating downgrade. If US Treasury debt lost its investment-grade rating, institutional investors would be prohibited by their mandates from holding it, while foreign investors, including central banks, would think twice. US borrowing costs would go up.

Some studies find that the dollar’s safe-haven status saves the Treasury upward of $700 billion in interest payments over a decade, enough, ironically, to fund nearly three-quarters of the bipartisan infrastructure package. There is some already evidence of this bonus being lost.

Uncertainty, as the COVID-19 crisis has reminded us, is what investors dread the most, and uncertainty would spike with an interest-payment suspension of unknown duration. Stock markets would react negatively. Moreover, because Treasury securities are used as collateral in a wide range of private financial transactions, short-term funding markets would be impaired if the Treasury was forced to suspend interest payments. Withdrawals would force money-market mutual funds to engage in fire sales of Treasury bills and, conceivably, to suspend redemptions.

Estimates of the economic fallout range from deeply damaging to catastrophic. One representative forecast suggests that GDP would decline by 4 per cent, while unemployment would rise to 9 per cent.

The Fed would step in, of course, as it does in every crisis. It would activate emergency measures discussed in the run-up to prior debt-ceiling crises. It would purchase defaulted Treasury securities and accept them as collateral in its own lending operations, albeit at their now-lower market prices. But this would put the Fed on thin ice. It would find itself in the middle of a political conflict. Democrats would criticise it for shielding Republicans from the consequences of their inaction. Republicans would accuse the Fed of complicity with the Democrats’ “socialist” agenda.

Clever analysts suggest that all this could be avoided if the Treasury simply put interest payments first. It could continue paying them in full as tax revenues arrive, while cutting other outlays by 40 per cent. But this assumes away formidable technical problems. (Think reprogramming the government’s computers.) And if you believe that Congress would be prepared to cut social security benefits and military pay to bail out bondholders, then you live in a political fantasyland.

Some hope remains. The Senate parliamentarian could allow the debt-ceiling increase to be attached to a reconciliation bill passed along party lines. The Democrats could swallow hard and vote for it on that basis, doing what’s right for the country regardless of the electoral consequences.

Or Republican holdouts could reconsider, given the gravity of their actions. Recall how, in the throes of the global financial crisis in 2008, then-US Treasury Secretary Henry Paulson went down on one knee to beg for leadership’s support after Congress rejected his $700 billion financial bailout. He succeeded, and the House passed the measure on a second try, with votes from Democrats and Republicans. But don’t hold your breath. The recalcitrant congressional leader then was the Democratic House Speaker, Nancy Pelosi. Today, it’s the Republican Senate Minority Leader, Mitch McConnell.

Barry Eichengreen is professor of Economics at the University of California, Berkeley. He is the author of many books, including the forthcoming In Defence of Public Debt. Copyright: Project Syndicate, 2021. 

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