Thursday, October 10, 2013

In Context, Weighing Different Ways to Avoid Default

-- Posted by Neil H. Buchanan

In my new column on Verdict today, I discuss the press's persistently incorrect framing of the President's options in the debt ceiling debate.  I frequently field questions such as, "Does the President have a way to raise the debt ceiling on his own?" or "Can the President just do what he wants, and ignore Congress?" or "Explain your argument that the President can simply go it alone" (emphasis added).

The problem with viewing the issue that way, as I have tried repeatedly to explain, is that the President is not going to choose whether or not to "go it alone."  He will be forced to choose how to go it alone.  That is really what the trilemma is all about: Faced with nothing but illegal options, the President will have to choose one of them.  He cannot pretend that failing to pay bills when they are due is legal.  Neither Professor Dorf nor I deny that issuing debt beyond the debt ceiling violates a statute.  He has to choose which illegal path to take.  (Whether he calls it "the least unconstitutional" choice is, as Professor Dorf explained again on Tuesday, a separate matter entirely.)

In short, this is another "context matters" moment, which I then extend to reply to those who claim that our proposed solution -- issuing debt without Congressional authorization, in amounts exactly sufficient to execute Congress's spending laws -- is simply unrealistic.  Professor Dorf and I have both been quite clear that we understand that this is untested ground, and that there is the possibility that the President's attempt to raise money this way might not find any buyers for the new bonds.  (I emphasize, however, that a financial industry that is capable of pricing "junk bonds" is surely capable of pricing Treasuries that carry the risk of being declared illegal months later in court.  They might not do so "efficiently," but they will surely be able to find a finite interest rate.)

My point in today's column was that those who dismiss the marketability of those bonds are making the same basic logical mistake as the people who say, "But issuing debt above the debt ceiling is illegal!"  (That is not surprising, because we are talking mostly about the same people in both cases.)  The question is not whether it is risky to issue debt without Congressional blessing.  It is whether it is worse to take that risk than to take the risk of default.

This is similar to the debate over various types of taxes.  I often point out that, in isolation, anyone can make a case that any particular tax -- the sales tax, real estate taxes, estate taxes, income taxes, whatever -- is "bad."  It is easy to tell a realistic story in which the existence of a tax makes something happen that we would wish to avoid.  But that is only the benefit side of the cost/benefit analysis of repealing that tax.  We should only get rid of a tax if we know what will happen after we do so: increasing other taxes to make up revenues (which ones?), cutting spending programs (benefiting whom?), or increasing deficits (in what macroeconomic context?).

Therefore, the interesting question is whether there are better ways to respond to a trilemma than to have the President order an otherwise-plain-vanilla bond sale.  In my column, I point out that the Federal Reserve could (and arguably will) step in and buy those bonds.  That would solve the marketability problem, along with a lot of other issues.  As I will explain in my Dorf on Law post tomorrow, I actually now think that this is the real Plan B that President Obama is understandably unwilling to disclose.

Intervention by the Fed, however, is not the only possibility.  Professor Dorf's former Columbia Law School colleague, Professor Jeffrey Gordon, forwarded a financing idea based on "super-coupon bonds."  The basic idea is that it is possible to promise big "interest" payments in the future, on bonds with a "principal" amount that is lower than the debt ceiling, but still raise enough money to fund the government.  I use scare-quotes on the words interest and principal for a very specific reason, which requires some background to explain.

The British government, back in the 1751, began to issue "consol bonds."  Consols were unique, in that the Exchequer would borrow a sum of money, but it would never pay back the principal.  Instead, the bond promised annual payments literally forever.  That is, the bondholder and his heirs would receive nothing but interest (coupon) payments each year in perpetuity, and they agreed in advance that His/Her Majesty's government would never have to pay back the principal.

This is important to think about in the context of the super-coupon bond proposal, because part of the genius of finance is how easy it is to change the labels on things, so that two financial instruments that are economic equivalents are formally quite different.  Indeed, because financial instruments are nothing but legal constructs, they are the essence of "form," making the substance-over-form touchstone of legal analysis problematic.  (In my field, tax law, we are told to adhere to substance-over-form principles, even when we are dealing with legal contrivances like corporations -- that is, "the corporate form").

In a fundamental way, therefore, all of modern finance (and, for that matter, all modern business law) can collapse upon itself, if we push on the definitions of forms too hard.  In an email, Professor Dorf cleverly described the super-coupon idea as "reverse Islamic finance," because the idea in Islamic finance is to act as if interest payments are principal payments, whereas in the super-coupon situation the idea is to act as if principal payments are interest payments.

Some finance specialists have even shown that the classic distinction between debt and equity is illusory.  Nonetheless, the law recognizes some formal distinctions (including debt and equity) while ignoring others (see, e.g., the "economic substance doctrine" in tax law).  Therefore, the question is whether the super-coupon approach would count as "not debt" for purposes of the debt ceiling statute.

My take on it is that it would count as debt, even in the narrower sense that debt is used in the debt ceiling statute.  Compare it to the consol bond idea.  If I borrow $100, and promise never to pay it back while paying an infinite stream of annual $4 interest payments, how much do I owe?  Well, I know that I borrowed $100, so that would be a pretty good way to determine how much I owe in debt.  In the case of the super-coupons, we would supposedly replace $275 billion in monthly spending commitments by issuing the new bonds.  Sounds like we would have borrowed $275 billion, not $100 billion (the formal amount that we would have retired in traditional bonds).

Now, one could argue that my method proves too much.  After all, future Social Security payments and other non-expiring obligations are not counted (even on a net present value basis) against the debt ceiling.  Maybe, therefore, the formal distinction between super-coupons and standard Treasuries should allow us to treat the super-coupons as "not debt."  I think there is an important further distinction, which is that future Social Security payments are simply projections of current law that can be changed on an ongoing basis rather than obligations, but I am sure there is at least a colorable response to that.

So, to me the better question is whether the Treasury should take the risk of issuing super-coupons rather than trying to sell standard Treasuries.  Whereas everyone would describe issuing additional standard Treasuries as exceeding the debt ceiling, many smart people would line up on the side of saying that super-coupons do not.  And that might really be all we need to know.  If there is a serious argument about whether this innovation falls on the "not debt" side of the blurry legal distinctions in this area, that might be less disrupting than a straight bond sale.

Moreover, even if my view turns out to be right, and the super-coupons were ultimately deemed to be debt that exceeded the statutory debt ceiling, that would only mean that issuing super-coupons was the method by which the President chose to follow Buchanan-Dorf and issue sufficient debt to honor Congress's spending laws.

The best news is that this would not look like the silly stunt that the Big Coin Gambit would have involved.  In any case, at this point, we are finally discussing matters in the context of bad choices.  We would not normally want to issue standard Treasuries without Congressional authorization.  We would also not normally want to test the question of whether the interest on super-coupons is or is not debt by another name.  These are not normal times, and either choice is better than default.

Again, this all assumes that the Fed does not agree to do the least-bad illegal thing.  Stay tuned for tomorrow's post.