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Debt Ceiling Showdown Redux: A Default by Any Other Name

by Joan Alexandre

Investment Analyst, Investment Management Research Group at 1st Global

Sir Isaac Newton’s third law of motion states that for every action, there is an equal and opposite reaction. Not only does this describe the symmetry of the physical universe, but experience and observation also reveal the principle at work in a broader sense: Every good thing has its opposite.

 

For law and order, there is crime and punishment. For onward and upward, there is down and out. For the stars and stripes, there is the budget and appropriations process of the U.S. Congress.

If an appropriation is a nail uniting both parties as they take their turns at the public trough, then a debt ceiling vote is the hammer each side wields against the other to wrest concessions.

The Debt Ceiling Process

It starts with spending. First, Congress passes a budget resolution that serves as the framework for the appropriations process; this resolution details not only budget totals but also the allocation of funds. Second, Congress accommodates this spending framework by implementing a procedural vote to raise the debt ceiling in order to “fund” these efforts.

Viewing this in terms of personal finance, appropriations are directly analogous to making purchases on a credit card; increasing the nation’s borrowing authority equals paying that credit card.

Created in 1917, the U.S. debt ceiling was the offspring of urgency and haste, ushered in during a time of war when ideological fault lines were narrow. Prior to 1917, Congress controlled both the budget and the purse. The legislative body dictated maturities and yield on all bonds except for certificates of indebtedness, precursors to the T-bill, which the Treasury could use for short-term borrowing and cash.1

Beyond the justification of expenditures, legislators had to arrange for their concurrent financing. Having begun in 1914, World War I’s costs were proving as difficult to forecast as its end was to predict. To provide some autonomy to the Treasury and increase funding efficiency, Congress passed the Second Liberty Bond Act of 1917, which established an elastic, aggregate limit on borrowing, allowing the Treasury to issue the best mix of securities necessary for the country to fund obligations on prior spending.

The Debt Ceiling in Modern Times

In a September 2013 “Fact Checker” column for The Washington Post, Glenn Kessler suggested that “generally, raising the debt ceiling has been routine and not especially controversial…although fiscal conservatives in Congress at times have used the debt limit as a way to force concessions by the executive branch on spending.” It depends on what is “controversial” to its author.

Congress had already acquired a well-earned reputation for having alligator arms when Richard Gephardt, a congressman from Missouri’s third district, was tasked by then Speaker of the House Tip O’Neill to pass an increase in the debt ceiling.

“We [democrats] were in charge of Congress, but nobody ever wanted to vote for [the debt ceiling]. Republicans wouldn’t give us votes. Every time it came up, I had to go to every member and seek [his or her] vote. I’d say to members, ‘Did you vote for the appropriations bill? The defense bill? The highway bill?’ They’d all say ‘yes.’ And I’d say, ‘Well, then you’ve got to pay the bill. If you didn’t mean it, don’t vote for it.”2

Looking for a more lasting solution to this problem, Gephardt consulted William Holmes Brown, then House parliamentarian, to determine whether borrowing increases could be incorporated into the budgeting process.

From 1979–1995, the “Gephardt Rule,” which assumed the debt ceiling was automatically raised once a budget resolution was passed, was adopted. This reconciled the paradox between Congress’ eagerness to spend but refusal to pay for its prior appropriations.

And for those 16 years, raising the debt ceiling was not particularly controversial. However, the rise of a new Speaker of the House in 1995 would change that.

Thanks in part to his “Contract with America,”3 Newt Gingrich won the speakership by promising various changes on The Hill, among them the Fiscal Responsibility Act. To conjure the illusion of fiscal discipline, he argued that repealing the Gephardt Rule would limit spending. This commitment to deficit reduction was tested when, by Gingrich’s own admission, the first of two government shutdowns resulted from a case of hurt feelings.

Despite an invitation aboard Air Force One to attend Israeli Prime Minister Yitzhak Rabin’s 1995 funeral, Gingrich was not included in the VIP seating with current and former heads of state. Further, Gingrich had to deplane using the back stairs. He later told a group, “I think that’s part of why you ended up with us sending down a tougher…resolution. This is petty, but I think it’s human.”4

Because the bond market is not in the habit of “pricing in” default risk on the presumed default risk-free asset, debt ceiling brinksmanship by lawmakers raises interest rates increasing borrowing costs. The speaker’s “tougher…resolution” included his refusal to call for the second vote raising the nation’s borrowing authority unless certain demands were met. Both Gingrich-led, debt ceiling stalemates increased the deficit by $1.4 billion in added interest — the same year he abolished the Gephardt Rule and one year after he established the “Contract with America.”5

Extraordinary Measures Meet Extraordinary Brinksmanship

Between 2002 and 2010, Congressional votes to increase the debt ceiling — the nation’s borrowing authority — passed without incident (10 separate occasions).6

In May 2011, Treasury Secretary Timothy Geithner sent a letter to Congress stating that the limit was reached once again, and “extraordinary measures” were necessary to extend borrowing capacity. These measures allow the Treasury to suspend issuance of certain securities (Treasury Securities — State and Local Government Series or SLGS) and temporarily cease funding certain pension obligations (Civil Service Retirement and Disability Fund and Postal Service Retirees Health Benefit Fund).

There was a hot wind blowing that summer as politicians crowed about “belt tightening” and “increased fiscal discipline.” Nevertheless, a deal was finally reached on Aug. 2 but not before adding $18.9 billion to the federal deficit in added interest expense7 and sacrificing the United States’ unblemished AAA credit rating.

Conferred in 1941 by Standard & Poor’s, this perfect score deemed securities issued by the “full faith and credit of the United States” as default risk-free. For 70 years, the country maintained this unsurpassed credit rating, a rating forged by both national tragedies and geopolitical shocks, such as WWII, a nuclear missile standoff, the assassination of a sitting president, the removal from the Bretton Woods System, Watergate, the energy crisis, a presidential assassination attempt during the height of the Cold War, the impeachment proceedings of a sitting president, foreign terrorism on U.S. soil, systemic accounting scandals, and a subprime mortgage crisis triggering one of the most severe recessions since the Great Depression.

“[The debt ceiling vote] is a hostage that’s worth ransoming. And it focuses the Congress on something that must be done.”8- Sen. Mitch McConnell (R-KY), 2011

On Aug. 5, 2011, Standard & Poor’s downgraded the U.S., citing “the brinksmanship of recent months [has] America’s governance and policymaking becoming less stable, less effective, and less predictable [with] elected officials [remaining] wary of tackling the structural issues on discretionary spending while delegating…decisions on more comprehensive measures.”9

Another Kind of Nuclear Option

In a Yogi Berra “déja vu all over again” bookend, Treasury Secretary Steven Mnuchin’s March 8, 2017, letter to Congress, indicated that the borrowing limit had been reached, and he was invoking extraordinary measures that could be exhausted as early as August or late as October, depending on the speed of revenue collection.10

With many of the same officials in place as before, it remains to be seen if the U.S. credit rating will once again be “taken hostage” for partisan leverage. For his part, Senate Majority Leader Mitch McConnell, who was heavily involved in the 2011 debates, has suggested “the debt ceiling must be raised.”11 More troubling is a revived discussion of the “prioritization of payments.”

Prioritization of payments, which is a euphemism for strategic default, occurs when the government funds some obligations but not others. This idea was suggested in 2011, again in 2013 and is on the table now. An informal plan was crafted from which it was suggested that among those last in the capital structure, receiving only what current revenues could support, would be social security recipients, veterans, government workers, and individuals on disability and unemployment12, but bond holders would be first in line.

Among the proponents of this technical default is Pennsylvania Senator Pat Toomey, whose May 2011 speech to the American Enterprise Institute revealed that he doesn’t believe prioritization will disrupt the economy as a whole but could negatively impact individuals who are dependent on programs that would no longer be available.13 Contrary to Sen. Toomey’s beliefs, it is more likely that people are accustomed to relying on benefits for which they have paid. For Social Security, the decades’ worth of contributions retirees have made haven’t been optional. Therefore, one would assume their statutorily guaranteed payments from the system wouldn’t be optional, either.

Rating agencies have taken notice, warning that this plan would most certainly warrant further downgrade(s), and the risk premium required to entice investors to trust a no-longer-risk-free asset would be staggering, making added deficit interest incalculable. As budget analyst Joel Friedman observed, “The fact that we’re even arguing about it is a small victory [to] those for whom government dysfunction is a means to an end. These representatives signal to their constituents: “Washington is broken. Send me there, and I’ll make sure it stays that way.”14

While many emerging and developing markets are subject to a debt ceiling, this mechanism imposes limits so that borrowing costs are reasonable, and poorer nations have access to international capital markets. Should Congress push the country past the 2011 brink by selectively defaulting on certain obligations, that access would become prohibitively expensive. Even more unthinkable is that all windows and doors to lending would be bolted shut — cutting off access all around.

Continuing the reversal from his 2011 positon, McConnell reiterated to a gaggle of reporters on Monday, Aug. 21, 2017, that there was “no way” the U.S. would default on its obligations. Was he sending a message to the Freedom Caucus that mischief would not be tolerated, or was he extending an olive branch to Democrats concerned about another possible “hostage-taking” showdown? In either event, it seems like the perfect opportunity for both sides to meet in the middle and restore the faith that Congress not only works but can also work to achieve a common goal.

 

All opinions expressed and data provided are subject to change without notice. Some of these opinions may not be appropriate to every investor. Past performance is no guarantee of future results.

 

1. & 6. Austin, D. Andrew. “The Debt Limit: History and Recent Increases” Congressional Research Service, November 2015 https://www.senate.gov/CRSpubs/d2c8f833-9796-4b3e-9462-6b1755ef463d.pdf
2. Green, Joshua. “How Dick Gephardt Fixed the Debt Ceiling Problem” The Atlantic, May 2011
3. Fallows, James. “Contract with America” The Atlantic, 1994
The contract was a document crafted by Newt Gingrich and Dick Armey borrowing heavily from Ronald Reagan’s 1985 State of the Union Address and featuring major policy changes which would be introduced as 10 separate bills to the 104th Congress should Republicans take back the House.
4. Sherwell, Phillip. “US shutdown: 1995 flashback when Newt Gingrich was ‘snubbed’ on Air Force One” The Telegraph UK, October 2013
5. Kaplan, Rebecca. “Government shutdown: What’s the cost?” CBSNews.com,October 2013
7. Chernoff, Allan. “Debt Ceiling Cost to Taxpayers” CNNMoney,August 2011
8. Fahrenthold, David, Montgomery Lori, Kane, Paul. “In Debt Deal, Triumph of the Old Washington” Washington Post August 20119. Swann, Nikola. “United States of America Long-Term Rating Lowered To ‘AA+’ On Political Risks And Rising Debt Burden; Outlook Negative” Standard & Poor’s Research Update, August 2011
10. Korte, Gregory, “Trump administration warns of upcoming debt limit” USAToday, March 2017
11. Carney, Jordan. “McConnell: ‘Ideally’ debt ceiling vote is before August recess”, The Hill, July 20017
12. Plumer, Brad. “If We Hit the Debt Ceiling, Can Obama Choose Which Bills to Pay” Washington Post,October 2013
13. U.S. Senate. “Sen. Toomey Gives a Speech on the Debt Limit at AEI.” May 18, 2011.
14. Bernstein, Jared. “Debt ceiling update: ‘Prioritization’ is Republican for default” Washington Post, October 2015