While consensus is building that the US defaulting on its debt or missing another payment could trigger severe consequences, many are soothing their worries by championing workarounds. These include invoking the 14th Amendment, which some argue requires Treasury to increase borrowing in order to pay obligations, and issuing a new kind of Treasury bond that only pays interest, and so technically would not add to the total stock of federal debt.
While use of unprecedented workarounds could indeed allow Treasury to continue to spend, such actions would not be without legal uncertainty and would not prevent immediate chaos or damage to the economy.
The only solution is to raise — or abolish — the debt limit.
Indeed, legal challenges are likely no matter what Treasury would try to do in the absence of new legislation, as the law requires Treasury to make payments, honor the debt and not go above the debt limit — contradictory obligations that cannot happen all at once.
The use of workarounds to make all payments would instill doubt about the federal government’s ability to perform basic functions. Financial market participants would anxiously await decisions from inevitable court challenges. Holders of Treasury securities would worry that courts would determine newly issued securities were invalid.
Even in the absence of a workaround, some argue that there would be no crisis if Treasury continued to make timely payments on certain obligations, such as principal on maturing Treasury securities and Social Security benefits, even as other payments were significantly postponed.
Some prioritization certainly seems less risky than an explicit and unambiguous default on Treasury securities, which would have dire consequences in financial markets.
But any prioritization of payments would be a crisis. If the debt limit binds — or prevents the Treasury from having
enough cash to meet all of its obligations — and Treasury delays non-interest payments (which would surely be considered by some a default on those obligations), the biggest immediate effects would be chaos in financial markets and uncertainty for businesses and households.
That chaos and uncertainty would arise for at least three reasons. First, as would happen if Treasury used workarounds to make all payments, there would be concerns about the ability of the federal government to perform its basic functions. Second, the negative economic effects of delayed payments would mount. And third, because there are legal arguments for and against prioritization, Treasury’s actions would have to be challenged and adjudicated in the courts, with the potential that courts would force a default on principal and interest.
In the meantime, financial markets would be in limbo. Would the uncertainty lead to a sharp reduction in demand for the securities that Treasury would issue to replace maturing Treasury securities? Would financial institutions refuse to lend to each other, prompting a liquidity crisis?
Whether the US ultimately delays a non-interest payment or instead Treasury pursues a workaround, the immediate ill effects would be similar.
Even a short-lived crisis would have lasting consequences. The shock to financial markets and loss of business and household confidence could linger. If nothing else, financial markets would likely anticipate such disruptions each time the debt limit nears in the future.
In fact, debt limit brinksmanship is already affecting markets. For Treasury bills that are scheduled to mature in early June, investors are demanding a premium of about 1.5 percentage points to shoulder the risk of not being paid on time — roughly five times the premium that emerged during the last two debt ceiling showdowns. With the public holding over $24 trillion in Treasury securities, further disruption in this market could reverberate through the economy and around the world.
Investors could reevaluate whether US Treasury securities are really risk-free, endangering the nation’s advantage in borrowing markets. The US government is estimated to pay a lower interest rate on Treasury securities because of the unparalleled safety and liquidity of the Treasury securities market. That advantage will save the US more than $750 billion over the next decade. But if a portion of this advantage were lost by allowing the debt limit to bind, interest rates on federal debt would be higher and the cost to the taxpayer could be significant.
This is not a government shutdown. This is not sequestration that leads to across-the-board reductions in appropriations. This is the threat that the US Treasury will be forced to tell people who are owed money that it is indefinitely postponing payments on bills.
Weaponizing debt limit brinkmanship and resorting to untested workarounds jeopardizes a healing economy.