On October 17, 2013 the United States Congress passed the Continuing Appropriations Act 20131, an appropriations law designed to restore supply to the various agencies and organs of the United States Federal Government which had been without legal access to public funds since October 1, 2013 resulting in a partial government “shutdown”. The Act also postponed the imposition of the so-called “debt ceiling” until February 7, 2014.
The debt default crisis of October, while not in the forefront of our minds, is far from over. The very same issues facing US legislators last month will resurface after Christmas. The political calculus of the actors in this drama might be different, as the government shutdown and debt ceiling roulette appears to have been very unpopular with voters. Some decision-makers might try to steer away from the risk of default in February, by refusing to allow the debt ceiling to be a lever in negotiations. Others, however, might convince themselves that the horrors of a default are overstated by the media and public commentary. Those decision-makers, should they exist, are wrong.
This bulletin explains how the debt ceiling works and why it is a major risk for both large companies and ordinary citizens.
The Debt Ceiling - A Major Legal Risk
The debt ceiling is a legislative limit on the aggregate amount of public debt the United States Treasury can borrow or issue at any one time. There is no unified piece of legislation governing the debt ceiling — it is a feature that has been added to a succession of generally budget-related Acts of Congress since the end of the First World War. Prior to the Continuing Appropriations Act, the debt ceiling was imposed by virtue of the No Budget, No Pay Act of 20132, which succeeded the Budget Control Act of 20113. The debt ceiling does not limit the budgeting or expenditure processes of the United States Government or Congress; instead, it is a semi-permanent, overall barrier to the issue of government securities, without regard to legal obligations to pay monies the Government may have in the intervals between hikes in the ceiling or other shocks to the treasury. No other major economy in the world has quite such a legal stricture on public borrowing.
The debt ceiling, and specifically the fact that a political process is needed to raise it, is a major legal risk to which all international capital markets participants are exposed. The consequence of not raising the debt ceiling in time to ensure the treasury’s continued liquidity would be a default on some kind of payment obligation of the US government. The imminent default on October 17, 2013 related to social security contributions and entitlements payments. On October 31, 2013 the Treasury would have missed bond interest payments. It is possible that incoming revenue (from taxes, for example) would have provided enough funds to fill the gap temporarily, but ultimately, the result of a failure to raise the debt ceiling is a wholesale “credit event”, rendering US treasury securities — long-regarded as the safest possible form of investment and a necessary metric of financial stability — not creditworthy.
Default on US Government securities would be a disaster for the global economy. Some US politicians, at the height of the shutdown, suggested publicly that default would not have the dire consequences predicted in the media. Such a view is simply incorrect: the reliability of US treasury securities, and the use of the US dollar, are pillars of the international economic system. A default would certainly freeze the global credit markets, require (at the least) a rebalancing of billions of dollars’ worth of synthetic derivatives products, devalue the dollar, and destroy public confidence in the ongoing, but fragile, economic recovery.
US Treasuries: They are everywhere
There are approximately USD 12 trillion in US government bonds now in issue. In addition to being generally sound, long-term, low-risk investments, sovereign bonds have other purposes. For instance:
- Capital Adequacy. A bank’s capital adequacy refers to the amount of capital it must hold in proportion to the amount of lending it may do. The capital a bank must retain for this purpose is referred to as a bank’s “regulatory capital”. Regulatory capital includes cash, but primarily comprises safe and liquid assets to which a bank might have access to offset lending losses.
Banks and certain types of financial institutions in most of the developed world adhere, through their respective national regulators, to the Basel Committee on Banking Supervision’s agreed formula for retaining adequate capital. That formula counts government-issued and backed securities among a bank’s “Tier 1” regulatory capital, being the safest type. US government bonds (and the debt of other, but not all, sovereigns) is certain to form a substantial part of the capital held by the globe’s financial institutions against its lending. Any rebalancing of the regulatory capital portfolios necessitated by a default would reduce a bank’s scope for providing credit.
- The Over-the-Counter (OTC) Derivatives Market. The global OTC derivatives market is a trillion-dollar world of private (hence, “over-the-counter”) arrangements between financial institutions and major corporate entities. The primary derivative contracts used in this market are swaps, which are structured by the globally-standardized terms of the International Swaps and Derivatives Association (“ISDA”).
The 2007-2008 financial crisis elevated counterparty risk — the risk that the opposite party to a swap will become unable to make the current and future payments required on the instrument — to public attention. Counterparty risk in swap contracts is mitigated in a number of ways, including collateralization. Collateral support for a swap position allows the non-defaulting party to obtain preferential recourse to assets that can be liquidated, with the proceeds applied to the default. The value of assets used for collateral is discounted according to the relative risk of default of the asset; such discount being known as a “haircut”.
US treasury securities are used, regularly and globally, as collateral support for swap positions. A default would have substantially increased the haircuts attributed to US treasury securities held for this purpose (even the threat of such a default likely had this consequence). The price of T-bills and other short-term instruments would plummet after default, reducing their intrinsic value as collateral. It is impossible to know now how big a problem this would become, but there is no guarantee that sufficient replacement collateral would be available to support a financial institution’s positions. Ironically, long-term US government securities might be the ticket for relief: US treasuries do not cross-default, so actual default on a short-term instrument (as might have happened on October 31, 2013 if a deal was not reached in time) would not automatically default longer-term paper, which could lead to a preference (and higher market prices) for long term instruments as substitute collateral.
- The US Dollar. Since the jettisoning of the Bretton Woods gold-backed monetary system in 1971, the Federal Reserve has maintained the value of the US dollar through the purchase of US treasury securities. Selling and buying US government debt in the open market is the primary means by which the Federal Reserve implements its chosen monetary policy. As a consequence, approximately twelve percent of US treasury securities are owned by the Federal Reserve; they make up the overwhelming majority of the Federal Reserve’s holdings. A decline in the value of treasury securities would drive down the value of the US dollar, increasing the cost of imports in the United States. In Canada, this would harm both exporters of manufactured and agricultural goods to the United States, and resource exporters whose commodities are traded in US dollars. Canada’s trade and export position to the United States and worldwide would be damaged.
- Funds. Money market funds, bond funds, income funds, growth funds, and “balanced” funds (a mix of the above) are all major purchasers of US treasury securities. A default would negatively impact the asset value of those funds, but might also compound the problem of dropping treasury security market values by adding to the cascade of treasury holders needing to sell. Many funds, particularly those promising security and focusing on long-term growth, cannot hold (by their own rules) defaulting instruments. Discounts are also applied to fund assets, much like the haircuts discussed above, to assist in mitigating risk within the fund’s portfolio. As such, any default would require the rebalancing and sale of assets, and possibly even a write-down of unsellable US treasuries. Funds-of-funds, being funds holding fund units, may have to divest of their holdings if such underlying funds could not weather the decline in value of their treasury portfolio.
This is a weak spot for ordinary people — Canadians and Americans alike. Many retail-level investors have a portion of their nest-egg in a fund product of one sort or another. This includes most pensions. On top of the overall loss of confidence a default would occasion, the vulnerability for fund products is a particularly thorny concern.
If businesses cannot borrow as banks are inhibited from lending, and middle-class investors see their portfolios decimated by collapsing funds and declining US treasury values, those at the economic margins of society feel the pain the most. Social Security, a US entitlement programme which makes regular payments to the elderly and the disabled, would be an early loser if a default occurred. The US social security fund is the biggest single holder of US treasury securities, and receives revenue directly from the treasury itself (collected by means of a payroll tax). The curtailment or deferral of social security payments would be a near-certain consequence of a default, even though the United States is obliged by statute to honour such commitments. Twenty percent of Americans use their social security benefits to avoid living below the poverty line.
The debt ceiling is, as noted above, the creation of statute. Acts of Congress over time have set the debt ceiling, and raised it. In the United States, as in Canada, the decisions of lawmakers are subject to, and must be compatible with, the Constitution. To put it bluntly, the Constitution trumps all other laws. The debt ceiling itself is within Congress’s constitutional gift to pass, but the breach of it is probably a violation of the US Constitution.
The Fourteenth Amendment is a sweeping series of juridical edits, promulgated in 1868 as one of many Reconstruction-era legal reforms designed to conform the US Constitution to the post-Civil War reality. The Fourteenth Amendment is best known to lawyers and the public alike as the location of the “Equal Protection” clause, which bans the States from depriving persons within their jurisdiction from the equal protection of the law. This clause was the legal underpinning of the US Supreme Court’s landmark 1954 desegregation decision in Brown v. Board of Education.
A lesser-known clause of the Fourteenth Amendment is section 4, which has nothing to do with equal protection. It states that “the validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” The President (and Congress) have an obligation to uphold the Constitution. As such, the Fourteenth Amendment might empower the President to simply order the debt ceiling to be raised (that order being directed to the Department of the Treasury, bypassing Congress, who would simply issue debt on that command). In other words, default might be unconstitutional.
The President and the Treasury are put in a particularly difficult legal pickle when confronted with the debt ceiling. As the ceiling is totally detached from mandated and authorized spending, the President breaches the law both by borrowing and by cutting back on spending. Congress tells him he must spend on certain things, but must not borrow (or tax, as taxes are also set by operation of law) to do it. The United States budget may be the most complicated document on Earth, but we can safely say that there is not enough discretionary slack in the system to allow a re-ordering of the payment priorities to permit the President to both spend, as obliged, and not raise income, as is prohibited. Breach of something is inevitable, but breach of the debt ceiling is the Constitution’s required approach if the credit of the United States is to come into question.
The Treasury has another option, one that respects the letter of law, but violates the principle of it. The Treasury Secretary can order the United States Mint to produce a huge-denomination (say, two trillion dollars) platinum coin, and deposit it in the Treasury’s account at the Federal Reserve Bank of New York. This money can be used to meet the government’s ongoing obligations. This is perfectly legal.
Title 31 of the United States Code sets out, in some detail, the specifications and denominations of coins. Most of it is pretty standard: a dime coin, for example, must be 0.705 inches in diameter and weight 2.268 grams. Subsections (a) through (j) make prosaic pronouncements about coinage, until sub-section (k), which is an aberration and appears to grant the Secretary of the Treasury great power when it comes to platinum bullion. It reads: “The Secretary may mint and issue platinum bullion coins and proof platinum coins in accordance with such specifications, designs, varieties, quantities, denominates, and inscriptions as the Secretary, in the Secretary’s discretion, may prescribe from time to time.”4
It could not be more clearly written than that: the Secretary has discretion to mint a platinum coin with anyone’s face on it, for any denomination at all. The law was intended, in all likelihood, for numismatic and collectors’ purposes — hence the “Platinum Eagle” dollar the United States occasionally mints. The intention of the law, however, is irrelevant for this purpose. The Secretary has a platinum superpower.
The platinum option is probably a nuclear option (as in, a one-time only minting), as Congress could immediately close the loophole the moment such a coin was struck. The President would have to sign such a bill for it to become law, unless his veto was overrode by a two-thirds majority in each house of Congress. The usual argument against the mass-production of money is its inflationary consequences. The Federal Reserve has means, however, to remove money from general circulation to tamp down inflation, and the effects might be muted by the fact that the platinum money is going straight into the Government’s reserve, to be used for pre-existing, known, and ongoing capital requirements. The market for dollars, presumably, would have anticipated a debt issuance to cover those costs.
The Centre Cannot Hold?
In the global capital markets, confidence is key to growth and health. The 2007-2008 liquidity crisis, followed by the ongoing sovereign debt stresses, have challenged many of the best-held beliefs that gave investors, both institutional and retail, faith in the system. A prospective capitalist, looking back on the past five years, could reasonably arrive at a point where she is sceptical of credit ratings, bearish on the real property market, reluctant to invest in systemically-important banks, and outright hostile to the idea that the market for credit products can spread risk in proportion to one’s appetite or ability to handle it. She could believe that some of the world’s biggest financial institutions colluded in the setting of the LIBOR rate without being labeled a conspiracy theorist. She could doubt whether the euro was a good idea without leaving the political mainstream. She could know and accept, having done everything right in retrospect, that her lifelong labour and enrichment will be, in the final analysis, less fruitful than that of her parents, or even their parents. It is sobering, and is it not yet over.
The importance of the creditworthiness of the United States is fundamental not just to the success of the global economy, but to its maintenance. It is the oxygen of the system. Debt and deficit reduction, entitlement and tax reform, healthcare, and generally better management might all be worthy priorities for US lawmakers. Political philosophies, as endorsed by voters, vary widely. All must take a back seat to the certainty that the United States is good for the dollar.
I have quoted Yeats; I will now quote Vampire Weekend. In the brilliant Hannah Hunt, Ezra Koenig sings that “though we live on the US dollar, you and me, we’ve got our own sense of time.” In that sentiment, which I am appropriating out of context, lies some comfort. In time, growth will increase treasury revenues, taking the pressure off borrowing and allowing the United States to get its fiscal house in order without imperilling its citizens and everyone else in the process. Eventually, the relative heft of the United States and the US dollar in the global economy will somewhat diminish. This latter phenomenon is overstated; China, the Eurozone, and the other BRIC economies all seek to play a greater role in shaping global flows of supply and demand, and so they will, but in my lifetime, it is hard to imagine the United States not holding a place of critical importance. It is a place the United States has earned through sustained economic growth and market-friendly public policies. Let that always be remembered, in the United States Congress and everywhere.