Don’t break the Treasury market while trying to save it
Stephen Miran and Dan Katz are co-founders of Amberwave Partners, an asset management firm, and served as senior advisers at the US Treasury from 2020 to 2021. Stephen is also adjunct fellow at the Manhattan Institute.
The US government may run out of money to fund appropriated spending as early as next week if negotiators’ latest push for a debt-limit deal doesn’t pan out. Given the proximity to the X-Date and the unpredictable consequences of a default, it’s worth revisiting the options to address the impasse.
The first and most straightforward path is what negotiators are currently working towards — a bipartisan deal that would lift the debt ceiling in exchange for future fiscal restraint. Such an agreement is the only good choice, in our view. With core inflation running north of 5% and a six-decade low in the unemployment rate, there has never been a better time for belt-tightening.
If Congress doesn’t raise the debt limit, the second option comes into play: so-called payment prioritisation, where the government would cease issuing new debt, finance spending with tax revenue, and choose which appropriations to fulfil until a deal is reached.
The Fourteenth Amendment to the Constitution provides that “the validity of the public debt of the United States . . . shall not be questioned.” The correct interpretation of this clause, as the Supreme Court held in Perry vs. US, is that the Constitution prohibits the federal government from defaulting on its debt. Outlays on government services are mandated by law, but debt service is constitutionally privileged above them.
Similarly, other categories of appropriated spending would be prioritised pursuant to the President’s constitutional obligations. In our view, payments for services rendered to the government by individuals and businesses will receive priority as a legal matter; these are similar to “public debt,” with a contractual counterparty with a property interest in payment. Legally, transfer payments would fall lower on the prioritisation scale. This is consistent with Supreme Court jurisprudence, including its holding in Flemming vs. Nestor that Social Security payments are not contractual obligations. This is why Congress can freely increase and decrease Social Security benefits and other transfers.
These across-the-board cuts would entail severe economic pain for transfer recipients like seniors, and are exactly why Congress should reach a bipartisan agreement on a sensibly designed fiscal package and lift the debt ceiling.
But they would be preferable to the third option: unilateral action by the White House to avoid the debt ceiling and fund all appropriated spending. While these unilateral measures could succeed in avoiding an immediate spending cut, they would end up gravely damaging the bond market.
While the above interpretation of the Fourteenth Amendment establishes payment prioritisation as a natural consequence of the debt ceiling, there is a more alarming interpretation that the Biden Administration is reportedly considering to continue spending unabated. Under this argument, the “debts” addressed by the Fourteenth Amendment are not just Treasury obligations, but all obligations of the federal government, including Social Security and all other spending appropriated by Congress. That would allow the Biden Administration to continue issuing additional Treasury securities on the basis that the debt limit itself is unconstitutional.
Legally, this approach is highly dubious. Section Four of the Fourteenth Amendment separately refers to “claims” and “obligations”, but notably only lists the “public debt” as that which shall not be questioned.
There is another problem with this proposal: the potential ruin of the Treasury market.
The legal status of Treasury securities issued in excess of the debt limit to fund spending would instantly be in question, and they would trade at a discount to older Treasuries because of the uncertainty. That discount could only be closed by an unambiguous legal holding that the new debt shares the same full faith and credit as the older securities. Furthermore, the existence of such a discount may itself provide standing to challenge the legal basis of the new debt, since holders of newly issued debt may suffer losses as a result of their questionable legal status.
A two-tier Treasury market would raise serious questions: To which class of Treasuries would you look for benchmark rates? Can trading and technology networks handle a bifurcated market?
What is certain is that a segmented bond market would impair Treasuries’ ability to serve as risk-free collateral underpinning the global financial system. Segmented sovereign bond markets are the kind of chaos one might see in defaulting emerging market countries, not in the source of the world’s reserve currency.
There are some potentially more legally permissible gimmicks to buy more time, such as repurchasing discount bonds or issuing premium or consol bonds, since the debt limit applies to the face value and not the market value of the debt. But given the limited supply of discount bonds and limited markets for premium bonds, zero-coupon bonds, and perpetuals, there won’t be sufficient liquidity for this to be a long-term solution. The debt ceiling therefore remains a binding constraint.
Another more radical path is to mint a “trillion-dollar coin.” This proposed solution, a favourite of the modern monetary theory crowd, holds that the Coinage Act allows the Treasury to mint a platinum coin in any denomination, and for any purpose, and deposit it at the Federal Reserve. By minting itself a huge cash infusion, Treasury would not need to borrow to fund the government’s expenditures, obviating the debt limit.
Bondholders would price an expectation of being repaid via future coins instead of taxes, meaning they’ll demand a steep discount in the dollar, undermining the Fed’s efforts to stem inflation. The money supply will permanently expand as well, driving inflation higher, as government spending will be funded by coin instead of taxation and debt issuance, the latter of which represents future taxation. If the Fed were to sterilise this increase in the money supply by selling its securities holdings, it would quickly send interest rates higher anyway, as a result of incremental Treasury supply coming to market. Moreover, the coin farce would destroy bedrock economic assumptions regarding the Fed’s independence.
What these unilateral approaches have in common is that in order to save the Treasury market from the debt limit, they destroy it in other, more creative ways. Perhaps that is why Treasury Secretary Yellen repeatedly refuses to endorse them.