Why Scott Sumner should love the debt ceiling
Suppose that the debt ceiling is never raised. Never ever. It remains in perpetuity at its current level of $16.7 trillion dollars.
Suppose also that the Treasury chooses to (and is operationally able to) prioritize payments on formal Treasury securities so that there is never a default on a US bond or bill. At or near the statutory debt limit, Treasury suspends other payments to build up a cash buffer sufficient to cover any spikes in payments due net of taxes. Once that is accomplished, Treasury securities can resume their role as the nearly default-risk-free asset at the center of the global financial system.
The question, then, is how are the other obligations of the US Treasury to be discharged? If the US government cannot (formally) increase its borrowings, then it is in theory subject to a cash-in-hand constraint. It can only spend the money it has, primarily in the form of funds on deposit at the Federal Reserve. (Yes, my chartalist friends, this is stupid, since the consolidated government/central-bank need never be bound by a financing constraint in a currency it issues. But in this case, the political system chooses, however bizarrely or foolishly, to constrain itself. C’est la vie!)
Humans, when ostensibly subject to a cash-in-hand constraint, do not in fact always live within their means. In particular, humans sometimes surreptitiously borrow money by writing checks against funds they don’t actually have. If I write a check for goods and services you provide today, you are lending me money. Usually that is mere transactional credit — an advance of convenience against funds I already have. But not always. If I write a check against funds I hope I’ll have in my account before it clears, you’re lending me money, whether you know it or not.
This is usually an expensive borrowing strategy for humans, because if I fail to assure an inflow of funds before my bank is ordered to pay the check, I will be hit by all kinds of costs — overdraft fees, returned-check fees, perhaps even fines or jail time if the “bad check” (defaulted loan) is deemed to be fraudulently arranged.
However, the government has a much cozier relationship with its bank than your typical check-kiter. Suppose the government, in response to the insoluble problem presented by congressional spending mandates and a debt limit, simply decides to pay all its bills as old-fashioned paper checks. It then asks the Federal Reserve not to “bounce” checks presented for payment against insufficient funds, but simply to hold them and make payments on a first-in, first-out basis as funds become available. Everyone who deposits a US Treasury simply finds that the funds don’t appear in their account until weeks or even months later. (Banks, in order to protect their own cash flows, would revise their “hold period” policies with respect to checks from the US Treasury, making funds available only when the checks actually clear, like they might with deposit of a large personal check.)
Suddenly, the debt ceiling is moot. Every check issued by the US Treasury is basically a credit line that does not count towards the debt limit. The Treasury pays its bills, on time and as usual, in the form of paper checks. It’s just that those checks clear a bit sluggishly.
Of course, recipients of US Treasury checks may not be happy to wait some indeterminate period before actually spendable funds appear in their bank accounts. There would quickly arise a liquid market discounting endorsed Treasury checks. Suppose “the market” expects payment of checks two months following a deposit, and the current short-term Treasury bill rate is about 1%. then you should be able to sell an endorsed $100 check from the Treasury for $99.83. Let’s call it $99.80, because the purchaser would want to be compensated for the uncertainty surrounding the exact time of payment. Of course, 1% is much higher than current T-bill rates. At a more realistic yield of 0.02%, you’d pay about a nickel per $1000 to redeem a two-month delayed check today, including some compensation for buyers’ uncertainty.
But this would be a very large market, and banks would quickly find themselves accumulating and trading billions of dollars of endorsed Treasury checks every day, with each day’s cohort trading at slightly different prices. The delay would initially be short, but it would expand for a while, then slow and eventually become pretty stable, somewhere (I am guessing!) between several months and two years. More precisely, the delay would be (total_debt - traditional_debt) / (tax_receipts - interest_on_traditional_debt). Traditional US Treasuries would remain actively traded in a $16.7T market, providing us with full risk-free yield curves. So we’d have good market predictions of the interest cost of traditional debt, and know the appropriate risk-free rate to discount for any length of delay. The only real unknowns relevant to pricing endorsed Treasury checks would be 1) the rate of future tax receipts and 2) a risk premium surrounding date-of-payment uncertainty. Date-of-payment uncertainty would itself be mostly a function of tax-receipt uncertainty. To a first, pretty good, approximation, the price of these these securities would just reflect a market estimate of the rate of future tax receipts relative to the known current stock of debt. One would have to adjust a little bit for illiquidity and uncertainty premia, but on these ultimately very low-risk securities, the adjustments would probably be quite small.
Holding tax law and the character of economic activity constant, tax receipts are pretty proportional to… nominal GDP. Of course, tax law and the character of economic activity are never constant. But periods of real uncertainty surrounding near-future tax law are infrequent, and the character of economic activity changes slowly. So a “futures market” in Federal tax receipts would not be a bad approximation of a futures market in nominal GDP!
I think Scott Sumner is the Svengali behind all of Ted Cruz’s antics. He must be. It’s the only sensible explanation.
I can’t quite wrap my head around what Treasury will actually do when the debt ceiling binds, if they won’t “mint the coin” or issue super-premium bonds, or invoke the “constitutional option”. Obviously the scenario described here is very speculative. But prioritizing Treasuries and slowing payments to everyone else doesn’t sound totally wacko. And if they do that, even if it’s not via paper checks, financial markets will try to figure out ways to discount and trade the loans implicit in delayed Treasury obligations. Maybe that will turn out to be a good thing!
p.s. i’ve been interested for a while in the possibility securities that pay-out fixed, predetermined sums on uncertain, revenue-dependent schedules. they strike me as a nice sort of debt-equity hybrid, offering some of the certainty of debt but much less hazard to issuers that payments will come due when they cannot easily be met. prices of such securities would be informative and easy to interpret. i’ve primarily thought about these with respect to small business finance. they seem an odd fit for a government that can in theory issue currency at will. such a government would pay for insurance it does not need because investors would on average demand a higher-rate of return than for fixed-term debt. but the informative prices might be worth the extra cost! and, in the debt-ceiling-forced scenario described here, the cost would be borne at least in part by recipients of government checks, who face an implicit tax.