No Default in Our Day

By: Michael Ashton | Fri, Oct 4, 2013
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I suppose it should not be surprising that there is a great deal of misinformation and misunderstanding about the debt limit and government default. A lot of people and especially folks in the media don't understand these issues because they have never confronted them, and the warring parties seem to believe they have an incentive to get the media telling their story by whatever means necessary, even if that means spreading disinformation.

Some of this is confusion among non-financial people about what "default" actually means. An individual defaults when he or she fails to pay bills within a reasonable time after they come due. If the default is serious enough, a creditor can force the defaulting party into bankruptcy and attach assets.

This isn't what it means to default as a sovereign country, however. A sovereign default is when a nation fails to pay interest or principal on its debt when due. And that's all. If the U.S. fails to pay its soldiers, that is not default. It's a bad move, perhaps, but it is not default. If the government doesn't pay you, you can sue...but even if you win, there is no Chapter 7 or Chapter 11 bankruptcy for the U.S. government so you cannot attach assets. So this distinction is key: if the U.S. services the debt, there is no default. This is the case whether or not the debt limit increases or not.

It is much more surprising to read James Baker, who among other things has been Treasury Secretary, equating the debt limit increase with solvency. Mr. Baker was interviewed for Peggy Noonan's column this week in the Wall Street Journal and said, speaking of the President, "He has to get the debt limit raised to avoid default."

We can walk this through and show why there need not be a default in the case where the debt limit is not raised.

While the government at some point ceases to spend, since it doesn't have Congressional authorization to do so, it still continues to collect revenue. The U.S. takes in a little less than $3 trillion per year in revenues, and if you think those taxes don't need to be paid while the government is shut down I invite you to try. Against that revenue, interest payments on Treasury bonds are on the order of $300bln (I don't have the exact figure). Principal repayments aren't relevant for this calculation, because as bonds mature the Treasury can re-issue the same nominal amount of bonds. So all the Treasury needs to do in order to avoid default is to pay the interest. They probably also want to pay the $1.6 trillion in Social Security and Medicare payments, and maybe a fair amount of the $700bln in defense and homeland security spending although a lot of that is procurement. But there's plenty more than is needed to avoid a default.

Incidentally, in theory the Treasury could take in more money by issuing Treasuries with above-market coupons. Perhaps there is a statute that requires the Treasury to always pay the minimum coupon possible, although I am not aware of it. But if there isn't such a statute, then the Treasury could raise more money by doing the following: when a $10bln TBill issue comes due, the Treasury immediately re-issues a $10bln, 10-year, 10% bond at a price of around 165% of par. Voila, an extra $6.5bln for the coffers. What is limited by statute, as far as I know, is the face amount of bonds that may be issued, not the amount of money that can be taken in.

Now, the Treasury claims that it is unable to pay selected obligations. According to them, it is not operationally possible - the check run is either on, or it is off. All, or nothing. This represents either ridiculous incompetence, or an outright lie. Seriously? The Treasury has no way to cut a single check if it wants to? How about this: take a big stack of blanks and, instead of running them through the printer, fill them out by hand and have the Secretary sign 'em. Painful? Absolutely. But it is inconceivable that it isn't possible to run only some checks. The Secretary should speak to his I.T. guys.

We should keep in mind that the Secretary is the President's former Chief of Staff, and probably knows a lot more about the politics of appearing to be unable to pay than he does the actual capabilities of the machinery.

Does any of this make default impossible? Of course not. There is always the possibility that politics or petulance cause the President to simply refuse to order the Secretary to prioritize interest payments on the debt. It would most likely cause dramatic long-term costs for the government and precipitate a real crisis, and I wonder if it might even be impeachable (the 14th Amendment does not seem to me to give the President the power to raise the debt ceiling and pay anything he wants, but it certainly seems to give him the power to cut checks in order to defend the "validity of the public debt of the United States authorized by law, including debts incurred for payments of pensions.") But there is no financial reason that failure to raise the debt ceiling should result in an actual default.


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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