The Debt Ceiling Debate

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“Between October 17 and November 1, we have large payments to Medicare providers, Social Security beneficiaries, and veterans, as well as salaries for active duty members of the military. A failure to raise the debt limit could put timely payment of all of these at risk.”
– U.S. Treasury Secretary, Jack Lew October 10, 2013 before the Senate Finance Committee

The Threat of Default

Default is defined as “failure to make a payment (such as a payment on a loan); a failure to pay financial debts”. A default by the U.S. in the words of Jack Lew, would be catastrophic. Creditors can overlook the United States’ dysfunctional monetary policy that prints trillions of dollars and a dysfunctional fiscal policy that racks up hundreds of billions of dollars in annual deficits, but they can’t look past not getting paid.

But that is not what the debt ceiling debate in Congress is about.

Each year the United States spends more than it takes in. Annual deficit spending has been the norm since 1940 with only the years 1947-49,1951,1956-57, 1960, 1969, 1998-2001 running a surplus. The United State also has an accumulated deficit with respect to money earmarked to be paid in the future. The amount of money the United States has obligated itself to pay out is a staggering $140-$150 Trillion. A large portion of these unfunded liabilities are to cover future Social Security and Medicare payments.

Non payment on these unfunded liabilities is inevitable as interest rates and spending rises. This is the real unaddressed problem, not the short term issue of paying interest on the debt later this month.

Currently, there is enough money to pay the interest on the U.S. debt from tax receipts. Indeed, there are more than 5.5X amount of dollars in the United States Treasury to pay the interest on the debt. Here is a 2013 monthly schedule of the interest on the debt and annual amounts owed 1988 through 2012. The U.S. owes $13 billion in interest on October 17th and about $25 billion in November.

There is also enough money to pay Social Security and make Medicare payments. There is not enough money, however, to pay for much else. Hence the call to raise the debt ceiling to pay for the rest of the government’s spending.

Prioritization of Payment Obligations

When faced with budgetary restrictions there are two choices: prioritize obligations or borrow more money, if available. Jack Lew says prioritization can not be achieved and therefore more borrowing is necessary. How much of this is political bluster and how much reality I don’t know, but I suspect the former.*

The bickering in Congress is over whether to prioritize the spending ( i.e defund ObamaCare and cut other future spending) or to continue to borrow more.

The stakes in the debt ceiling debate have been raised unnecessarily to an all or nothing proposition – the U.S. either raises the debt ceiling to continue borrowing to pay for every last bit of government spending or it defaults. There is a third alternative: the Congress and/or the President agree to prioritize what gets paid.

Here is a short prioritized list of government spending:

– Interest payments on the United States debt;

– Mandatory Spending – Social Security and Medicare;

– Discretionary Spending of the Executive Branch including spending of the Departments of Commerce, Defense, Energy, Education, Housing and Urban Development, Transportation, Energy, Education and Homeland Security; and

– Discretionary Spending of the independent agencies of the U.S. Government like the Environmental Protection Agency, the CIA, TSA, NSA, FBI, SEC and the Post Office.

The current budget standoff and threat of default on October 17 may be resolved under any of the following three scenarios:

1. The Jack Lew Doomsday Scenario

Extremely unlikely

Under this scenario, the debt ceiling is not raised and there is a default on the debt and social security and medicare obligations don’t get paid.

For this to happen there would have to be a willful default because if the Congress does not authorize an increase in the debt ceiling, the President must prioritize the spending based on the available funds.

Jack Lew characterizes not paying social security as a default. This is incorrect. Not paying social security or food stamp or welfare payments is not a default; it’s a failure to pay an entitlement. No one in the United States contracted to receive social security, food stamps or medicare, they were promised them. Medicare payments, in contrast, are owed under contract to third party medical providers. Failure to pay these obligations could be characterized as a default.

However one characterizes non payment of Social Security, Medicare and food stamps, their non payment coupled with non payment of US debt obligations would be an economic disaster. Therefore, in the event that Congress refuses to raise the debt ceiling, its hard to imagine that the President would willfully refuse to pay interest on the debt and social security and medicare obligations first.

The bond market seems to be relatively complacent regarding an event of default by the United States. The relatively unchanged yield on the U.S. ten year note (so far) looks like the market views a default as highly unlikely. The yields on the short term U.S. debt obligations, however, have risen and reflect some price risk of a default.

2. The Debt Ceiling is Not Raised But a Default is Averted

Extremely unlikely, but more likely than scenario #1

This essentially would result in a balanced budget. Under this scenario the United States’ obligations would be prioritized in a bill passed by Congress authorizing spending just the amount up to the debt ceiling. Obligations for which there is no funding (above the debt ceiling) would not be paid. The same result can be achieved if Congress does not pass a bill raising the debt ceiling and leaves the matter to the President to trim additional spending to keep it within the debt ceiling limits.

This scenario is unlikely because when politicians want more money they never threaten to cut unnecessary spending that the public is either unaware of or would fall low on their priorities, rather they threaten the loss the services the public wants and or relies upon the most to get the whole budget passed. It would be out of character for Congress to take the time to start eliminating portions of the military budget, cancelling foreign aid, curtailing funding for the arts, farm subsidies and environmental grants to keep spending under the debt ceiling.

There is probably not enough desire or time to do prioritize spending by the 17th of October. Jack Lew has also said the United States’ payment systems can’t accomplish prioritized payments. The law of payment systems probably comes into play- payment systems are capable of performing only such functions at the operator’s direction and in the operator’s best interest.

Congress also knows that a sharp and immediate cut in government spending would, at least in the short term, have a dramatic adverse negative impact on the economy. Since Congress and the President have a vested interest in continued spending and don’t want to send the economy into a tail spin, not raising the debt ceiling and prioritizing only essential spending seems highly unlikely.

3. A Deal is Worked out to Raise the Debt Ceiling and Avert a Default

Most likely

This scenario starts with a short term extension to continue to fund the parts of the government that are not shut down, pay the interest on the debt and social security and medicare obligations past the October 17th debt ceiling deadline. Later an agreement to cut spending or the growth of spending in the future will be exchanged for an agreement to raise the debt ceiling. The debt ceiling may be raised to cover most or all of fiscal 2013 spending.

What Would These Scenarios Mean For:

The Economy

The current government shut down and Congressional wrangling over the budget has sent the stock market down for the past two weeks. The stock and real estate markets appear to be the only bright spots in the current economy. Scenarios #1 and #2 mean short term pain for both the real estate and stock markets and the economy. Significant and beneficial restructuring of the economy, however, may take place over the longer term if government spending reductions become permanent and capital moves from the less efficient public sector to the private sector. Scenario #1 necessarily means higher interest rates as investors would demand higher rates given the potential of the United States to default again. Higher rates would mean the U.S. would have higher costs of borrowing and would have to cut its borrowing and spending further and short term the economy would experience a sharp decline.

Scenario #3 means the potential for the stock market bubble to carry on for a few more months, but does nothing to avoid the day of reckoning regarding the United States’ untenable debt load and inevitable default.

Real Estate

In the past few months the mini housing recovery started losing steam as a result of higher interest rates and a lackluster labor market. The government shutdown is now also starting to wear away at the housing recovery. New home purchase loan mortgages are impacted as the IRS and Social Security Administration are closed and important documents to verify income are not available. In addition, mortgage approvals from the Federal Housing Administration which is operating with a skeletal staff have slowed and the U.S. Department of Agriculture, which backs mortgages in rural areas, is not taking on new business during the shutdown.

The momentum in the housing market appears to be lost, especially going into the slower fall season. Under scenarios #1 & 2 interest rates would skyrocket and economic activity would come to a standstill and not only would the housing recovery be over but a decline in home prices would be likely.

Scenario # 3 holds some hope for a continuation of the easy money policies that helped partially reflate the housing market. Unfortunately, some steam has already been let out of the recent housing bubblet and it will take more than just low rates and a continuation of quantitative easing to push the housing market higher.

Gold and Silver

Under scenario #1 precious metals should rise in value and regain their safe haven status as the safe haven perception status of U.S. Bonds will have been shattered by default.

Under scenario #2, where the debt ceiling is not raised and absent Federal Reserve action, the prices of gold and silver would get crushed as spending would be reigned in causing the dollar to gain strength.

Under scenario #3 precious metals should rise as raising the debt ceiling would mean continued deficit spending and debasement of the currency.

It’s Not Dark Yet, But It’s Getting There

*Caroline Baum, reporter for Bloomberg points out that the Government Accountability Office contradicts Jack Lew’s claim that the U.S. Treasury can not prioritize payments. Click here for further analysis.