Friday, October 11, 2013

The Debt Ceiling, the Fed, Obama's Risky Strategy, and Related Thoughts

-- Posted by Neil H. Buchanan

Yesterday, here on Dorf on Law, I promised that today's post would present my view that the Federal Reserve must inevitably be the savior that prevents a default, should the Republicans' refuse to increase the debt ceiling.  Before making that argument, however, I will offer three short comments on related issues.

First, in his op-ed in today's NYT, Paul Krugman essentially adopts the "choosing from among nothing but bad choices" framework that Professor Dorf and I have been advocating (literally for years, but most recently in yesterday's post).  He links to a Washington Post WonkBlog piece that carefully describes our work and that quotes extensively from an interview with Professor Dorf earlier this week.  This framework, of course, would be especially likely to make sense to Krugman, because he always uses his economics training to analyze real-world tradeoffs, not abstract fantasies.  In any case, it is good to see that the conversation is turning away from the idea that there is no other choice for the President but to default.

Second, Krugman starts to make a point that I have been thinking about for awhile.  He notes that, during the 2007-09 crisis, "Wall Street was bailed out but distressed workers and homeowners got little or nothing."  If we now "prioritize" paying bondholders, in the way that many of the true believers in the Republican Party insist that we can and should, "[w]e would, once again, be signaling that the financial industry gets special treatment because it can threaten to shut down the economy if it doesn’t."  Quite so, but the larger point is, I think, more significant (and even, in its way, poignant).

The Tea Party's origins are deeply based on the idea that "bailouts" and special treatment are wrong, wrong, wrong.  An early Tea Party upset, when arch-conservative Republican Senator Robert Bennett lost his Party's nomination in Utah to now-Senator Mike Lee, was accompanied by frenzied Tea Party activists in the convention hall, angrily chanting, "TARP!  TARP!  TARP!!"  TARP (the Troubled-Assets Relief Program) was the core bailout provision that enraged and mobilized the right-wing populist base.  Once again, therefore, we are seeing that the big money guys are using the "rubes," who actually thought that there was a way to prevent Wall Street from getting special treatment.

Third, most of the debt ceiling debate is obviously about framing the issues.  Republicans want people to believe that refusing to raise the debt ceiling is about controlling debt, whereas Democrats say correctly that the debt ceiling prevents the government from paying its already-existing debts.  Among all the different ways that I have heard people try to make this point, my father-in-law came up with my favorite: "My wife and I have decided not to pay our electric bill this month, because we don't want to raise our debt ceiling."

(On a different topic, Jon Stewart offered a similarly clarifying analogy last night regarding Republicans' claims that everyone has access to health care through free emergency rooms: "Don't say that we don't need Food Stamps because we already have dine-n-dash."  Brilliant.)

In any case, I argued yesterday in my Verdict column and here on Dorf on Law that the best of the bad choices, when we reach the drop-dead date for the debt ceiling, would be for the Fed to step in and buy the additional bonds that the President would have to issue in order to avoid default.  Because of the possibility of a "failed bond sale" (which, I continue to believe, is a very low-probability event, but not impossible), the Fed could decide that its fundamental duty to protect the global financial system requires it to step in and buy the new debt that would be needed to finance Congress's spending laws.

I have recently come to believe that this is not just what the Fed might do, or even that it should do, but that the Fed must buy those bonds.  The problem is simply a matter of timing.  Whenever the drop-dead date is reached, the President is committed to forcing Republicans to back down.  If they stand firm, and the clock hits 11:59:59 pm, then it will be simply impossible to carry out the public bond sale that would be necessary to avoid default.  (That, by the way, is also true of the super-coupon bonds that I described in yesterday's post.)

At that point, there really are only two possibilities: the President follows Buchanan-Dorf by getting the Fed to buy the bonds, or there is a default.  I do not see how the Fed can allow the latter to occur.

This shows just how dangerous is the President's stare-them-down strategy.  Many liberals have said to me recently, "But don't you think that the President has to pretend that he's not aware of your argument, to keep up the pressure on Republicans?"  And they are surely right.  Once the President decided on his current strategy, it required him to maintain his poker face, which further requires him to deny that there are any other possible routes.

Last week, I argued that the President still has the last word on this, because at midnight, he is the one who has to choose whether or not to default.  Or, as I was quoted in The Wall Street Journal earlier this week: "The Obama people are committed to not blinking. If Republicans don’t blink either, then the last mover in this drama is the president. He can float some bonds or default on the obligations, but he’s the one who has to make that tragic choice."  That is still true, but the problem is that floating bonds takes time.  That is why the Fed will have to act.

All of which lends further support to the argument that the President should have announced as early as possible that the debt ceiling is a dead letter.  The best recent date would have been March 31 of this year, right after Congress passed the continuing resolution that kept the government running through September 30.  Announcing then that he would always choose more debt rather than allowing a default would have given everyone time to freak out, a few news cycles to pass with newspapers filled with conflicting opinions over his strategy, Republicans vowing impeachment, and so on.  Most importantly, the President would have time to make the point, over and over, that all of his options were bad, and that he was choosing the least bad among them.

By the time the debt ceiling was reached, the financial markets would have had time to assess how to respond to a bond sale, and the mechanics could have been in place.  It would still be white-knuckle time, but it would be in some ways old news.  Even if Obama had been impeached by the House, the Senate could have acquitted him in a matter of minutes.  I am not saying this lightly, but I am saying that the reason many people reject the Buchanan-Dorf analysis is that it is unfamiliar, and thus seems like something that the public would not accept.  Had the Administration decided to go that route, however, they could have taken advantage of the summer months to make the argument seem not just familiar, but obviously true (which it is).

Instead, they decided that there is political advantage to a strategy that fundamentally guarantees a last-minute standoff.  That might work out, with either the Republicans blinking or the Fed stepping in, but it was unnecessary and incredibly risky.


Unknown said...

I think Treasury will adopt the "prioritization" on bond payments being proposed. This is clearly congressional Republicans preference. But I think the consequence of this action is likely to be a breach of the debt limit. Consider that if Treasury turns off its other payment systems, SS funds will very quickly be in surplus and by law, Treasury will have to convert those funds into SS Treasury bonds (P.L. 104-121 "Specifically, the Secretary of the Treasury and other federal officials are required not to delay or otherwise underinvest incoming receipts to the Social Security and Medicare Trust Funds"). Since the debt limit is only 25M below the legal max, intragovernmental debt will quickly exceed the limit at which point Treasury can just say, "oh well, we tried but look what happened. guess we'll just ignore the debt limit and proceed as usual." Hopefully, that would be the end of the nefarious debt limit and not too much damage will have been done to our credibility.

Paul Scott said...

"then it will be simply impossible to carry out the public bond sale that would be necessary to avoid default."

While I agree with the "Fed as buyer" approach I don't think the above quote is right. My understanding of "reaching the debt ceiling" is that there is still considerable variation in the day to day in-cash/out-cash and that it would be very likely that once the debt ceiling was reached, that it would then likely take several more days, if not weeks, before an actual default might happen.

IIRC, Lew said something to the effect that the US would have about $30B in cash, but that our government sometimes had $50B days.

If that is the case, the a public sale seams reasonable. Though, for other reasons, mostly relating to cost of the illegal bonds, the Fed is the right buyer since it could buy them without reflecting a premium for their illegality.

One way out for everyone, it seems to me (I started thinking about this yesterday) is to put through legislation that reduces the debt ceiling (every can claim victory) but then eliminates categories of debt currently counted - namely money the US government owes itself. There is no good reason to count the $2.5T the Fed owns or the $2T "owed" to SS, etc.

If you redefined debt in the statute to only count debt not owed by the US Govt. to the US Govt. you could cut the debt ceiling by about 33% and be exactly where we are now. So if you cut, instead, by say 30% you have a huge cushion for additional debt and you permanently solve the issue. The debt ceiling can permanently be relegated to "show pony" status since in the future if such problems arose the Fed could buy Treasuries and immediately create a gap ("creating" money in the process and thus in more normal times causing an inflation risk).

I know this is sell-able as a win for everyone to the public in the short term. In the long term it eliminates "out of control debt" as a tool for Republicans wanting to cut back on security net funding, so it still may be a non-starter.

Anonymous said...

You said, "the Fed could decide that its fundamental duty to protect the global financial system".

That is not in fact the duty of the Federal Reserve, instead it is to regulate the United States money supply.

Unknown said...


"If you redefined debt in the statute to only count debt not owed by the US Govt. to the US Govt"

Debt held by the Federal Reserve isn't intragovernmental so future purchases would still count against the debt limit. But it would still create a $4B cushion for the Treasury if you only reduced the limit by a small amount (or not at all)

Paul Scott said...

That is why I did not use the term "intergovernmental debt" - e.g. Treasuries held in US trust funds (like SS). I am sure that definition is missing some other intergovernmental debt, but US trust funds should cover most of it (maybe there are a lot of treasuries held in the FFB, but I don't think it represents a significant dollar value on the scale we are discussing).

I can think of no good reason to consider Treasuries held by the Fed as if they are the same thing as Treasuries held by the public. As I understand things the buying and selling of Treasuries is done by the Fed to indirectly control interest rates (by effecting the yield on Treasuries) and has a secondary effect of controlling the US money supply. These effects are limited right now because interest rates can't go below 0, but that is what is supposed to be happening.

I guess as I type this I can see one reason to consider Treasuries held by the Fed as part of our debt - you would not want the actions of the Fed to put us over our debt ceiling in the event that it needed to sell Treasuries to curb inflation. I am not sure that is a great concern, since inflation is a great way to devalue currency and if our debt were truly unmanageable, the Fed would be wise to encourage inflation, but still I can see at least a theoretical reason to consider debt held by the Fed on par with debt held by the public.

Paul Scott said...

The regulation of the money supply is a means by which the Fed acts, it is not itself a goal or duty.

Neil might be stretching with the addition of the word "global," but if so, not by much.

The Fed is primarily responsible for balancing the competing goals of inflation and employment. The supply of US dollars plays some role in executing that responsibility (though a lot less than most people give it credit), but it is certainly not a duty in its own right.

I'd also say that Neil's statement to which you take issue is far more correct than it is wrong. The US is special (though the Tea Party - in this limited instance would like you to think otherwise). As a result, the Feds duty to balance US employment and inflation *is* a de facto duty to protect the global financial system.

Unknown said...

I guess I'm confused by "US Govt to US Govt" as that is the definition of intragovernmental and the Fed isn't part of the US Govt. Treasuries held by the Fed are the same ones as those held by the public.

I agree that intragovernmental debt shouldn't count against the debt limit, but you're sure to inflame the "SS Trust fund isn't real" crowd.

Paul Scott said...


I am happy to be wrong about this, but my understanding of the term "intergovernmental debt" was that it covered specific categories of debt and that among those was not holdings of the Fed.

That was why I tried to use a more generic phrase. It is news to me the the Fed is not part of the US government. But maybe all you mean by that is that it does not fit in one of our three branches. In some technical ways it is also not "part of the US government." But in all substantive ways it is.

It was created by Congress and its mandate was set by Congress. At any time Congress could change any aspect of the Fed or abolish it altogether and no one would have a cause of action against such legislation. The Fed's board is appointed by President. The annual "profits" of the Fed are credited to the US Treasury. Its authority, including its independence from *direct* review (though, again, not indirect review via legislation), is derived entirely from acts of Congress. In fact, again by statute, the Chair of the Fed must report to Congress twice a year. Additionally, as I understand it, the President can, in fact, remove a member of the Board of the Fed - including its chair and vice-chair. Though this has to be for "cause" and presumably "I don't agree with the decision of the Chair" is not "cause" - though this has never been attempted or challenged to my knowledge. This is only to say that the independence of the Fed is far less complete than is generally understood.

I appreciate that that independence, incomplete that it may be, is critical to its function. In many ways it is really not substantially different from Federal magistrates.

Additionally, that independence - without regard to review - itself is limited by statute. It is not as if the Fed can act at will like any US Corp and, say, start a chain of motorcycle shops. It has some very specific mandates and very specific means by which it can act to support those mandates.

A great example of those limitations is that it has no power to implement fiscal policy. If it did, Bernanke (who has been very critical of our fiscal policy) would do so. A non-governmental body, in contrast, can make changes to our fiscal policy (though I admit we do not commonly think of it that way - preferring to keep the artificial distinction between governmental and private spending, even though it is only the total spending that matters and not where it comes from.)

Anyway, I think there are reasonable arguments for considering debt to the Fed as true debt (and thus against our debt ceiling), I don't think one of those reasons is "because the Fed is not part of the US Government."

Unknown said...

"my understanding of the term "intergovernmental debt" was that it covered specific categories of debt and that among those was not holdings of the Fed."

I actually don't know if it covers categories or types of debt as distinguished by the instrument. Certainly all the GAS are intragovernmental, and I'm unaware of any other part of the govt holding T-Bills, T-Notes, and T-Bonds that are counted as intragovernmental debt. The GAO says intragovernmental debt is "special US Treasury securities" implying that it does not include bills, notes and bonds. It seems unlikely that intragovernmental does include bills, notes and bonds since the accounting would be a nightmare, i.e. a purchase moving debt from public to intragovernmental.

I suppose my statement on the Fed should have been qualified: the Treasuries that the Fed purchases on the open market aren't considered a US Govt asset so in that respect the Fed isn't part of the US Govt. That's sort of the point. That the Fed exists in this sort of quasi govt/private nexus is by design. You're absolutely right, I shouldn't have definitively stated that the Fed isn't part of the US Govt.

To the larger point on Fed holdings of govt debt, the Fed's holdings must be considered separate from the govts for it to function effectively. How would the Fed's open market purchases affect interest rates if its holdings were a de facto asset of the US Govt? Wouldn't those purchases likely be considered as monetization of the debt? And as you pointed out, sales to curb inflation would in effect be creation of new debt subject to limit.

This actually addresses one of points in the original post about Fed open market purchases, "I have recently come to believe that this is not just what the Fed might do, or even that it should do, but that the Fed must buy those bonds." I'm not entirely sure that the Fed can buy those bonds since the Federal Reserve Act restricts govt security purchases to "any obligation which is a direct obligation of, or fully guaranteed as to principal and interest by, any agency of the United States." Would the securities issued by Treasury in excess of the debt limit be considered fully guaranteed? Actually, are they illegal? Determining which Treasuries are illegal, if that can even be defined, might be mitigated though an issuance of very short term debt that spans the debt limit. I don't see any way that some of those securities could be considered legal and others illegal.

Paul Scott said...


Yeah, on how to treat the Fed's holdings of US debt, we are in agreement. You convinced me or I convinced myself even as I was writing my original post. I want it to work as a permanent fix to the debt ceiling, but it just can't and have the Fed still function.

I'll stick with the idea of it being a win-win for everyone to "lower" the debt ceiling but categorizing intergovernmental debt out of the calculation. I think that can be sold as both reform and as "staying tough on debt." You just need to leave yourself about $1T in cushion to get us through this presidency, which is easily accomplished.

I find the discussion on the status of the debt issued illegally an interesting point as well. It is not clear to me that illegally issued debt is itself invalid and/or not fully guaranteed. It might be true, but it is very complicated, at the minimum.

Paul Scott said...

Looks like Obama is about to make another huge mistake.

From NYT:

"As they drafted their deal, Senate negotiators in both parties were hoping that House Republican leaders would have no choice but to let a bipartisan agreement struck on the verge of default come to a vote, even if it could only pass with votes from Democrats and a minority of the Republican majority. The deal is likely to include two concessions to Republicans: a two-year delay of a tax on medical devices that helps pay for the health care law, and some tightening of qualifications for subsidized insurance purchases."

So, short extension of the debt ceiling and a similarly short reopening of government in exchange for 2-year delay and a change in government health subsidies to the poor.

OK, so the MDT isn't something Democrats really want (it was only in there to help the law be "self funding."). Still, it is a give away to extortion if he allows it. The "tightening" (e.g. making sure fewer poor people qualify) of requirements for subsidies is likely to effect tens of thousands of our poor. All in exchange for 6-8 weeks of government.

He really needs to stick to his no compromise pledge on this issue and just find some way to defy Congress (sell Treasuries illegally, mint a coin, "print" money illegally - I don't care). It's just going to happen all over again in 6-8 weeks where he will once again give something up. If he keeps to this pattern he is just telling the Republicans that "yeah, this extortion thing really works, just not as fast as you had originally hoped."

Very disappointing; not particularly surprising.

funnygames said...

As I understand things the buying and selling of Treasuries is done by the Fed to indirectly control interest rates (by effecting the yield on Treasuries) and has a secondary effect of controlling the US money supply. These effects are limited right now because interest rates can't go below 0, but that is what is supposed to be happening.Fifa 14 Ultimate Team Coins
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