What Happens if the U.S. goes into default?

Some people think that this is going to be like when the federal government shutdown in 1994.  For those who remember it, it meant things like national parks were closed, several agencies were shutdown, and many federal workers got an unpaid layoff.  While those things had a negative impact on the economy, a failure to raise the debt will be disastrous in comparison.

Why this will be different all comes down to the two different kinds of government spending.  Mandatory and Discretionary.  Mandatory spending are things that get automatically spent based on current rules.  For instance, when you’re 65, you get social security.  Congress doesn’t have to pass a special law for that to occur.  Discretionary spending is programs and agencies that must be renewed every year.  For instance, the commerce department only gets a budget to hire so many people every year.  During a shutdown over the federal budget it’s employees go home, but any bills it already agreed to pay are honored.  Same with Social Security.  People who work for Social Security during a budget showdown will be sent home, but the people on Social Security will continue getting their checks in the mail.  This is not true over a problem with the debt limit.

With the debt limit, once it’s reached, no new government checks will be issued.  So everything that happens during the 1994 shutdown will happen plus more.  States and local governments won’t be re-imbursed for education expenses.  Social Security payments will be missed.  People won’t be able to exchange their U.S. bonds for cash.  Now you can start to see why this is going to be so bad.  States and local governments will be hurt, retirement plans that depend on U.S. treasuries will be hurt, doctors won’t get reimbursed for their medicare patients, and worse anyone who depends on social security just to scrape by will be devastated.  All of the things that the federal government has already committed to paying for (via law) will now go unpaid for.

So is the U.S government going to default?  Even though all limits on the Federal Government’s finances is self-imposed, it is still possible to volunaterly default.  So, Whether or not there will be a default, is entirely a political, not financial question.  Not raising the so-called debt limit is one of the ways to voluntarily default.  Unfortunately, the geniuses in Washington may be about to do that for the first time in the history of our country.  My guess is that the chances of a voluntary default seem about 50-50.

So what should we expect and what should be done in preparation for a default?  I would expect that most of the federal government will shutdown.  Officially, people and departments will still be “in business”, but it won’t be able to pay its employees or contractors so they’ll all have to be sent home.  This poses a problem for those in the armed forces.  My guess is that if you’re in the armed forces you won’t get sent home nor get payed for a while.  However, when the deficit limit is raised, you will get your full back pay.  In fact, I’m pretty sure that goes for any government assistance to states, cities, or people.  You’re going to go without pay for a while, but the politicians raise the debt limit, all back pay will be honored.  The reason is that, by law, these groups are owed this money.  I’m not a lawyer, but I’m pretty sure that means the back pay will have to be redeemed.  However, I wouldn’t hold out hope for getting payed interest for the late payments.

As unprecedented as a voluntary default is, I think most of what’s going to happen is fairly predictable:  Most government workers will be sent home without pay and there will be a delay in sending out government checks.  The only wild card is what’s going to happen to the bond market?  U.S. treasury securities have always been a no-brain safe investment.

If banks and investors can no longer turn in those due U.S. securities, what’s going to happen?  First of all, I am 99% sure that those bonds will eventually be honored once the debt limit is raised.  In the meantime, what’s going to happen.  I am not certain.  A lot in the media think that it means that interest rates on everything is going to go up.  But, these are the same people that think the federal government can run out of money.  So, I’m not going to just take their word for it.  The theory is that the U.S. bond market sets the overnight interest rate.  Banks (for the most part) set their long term interest rates on how cheaply they can get more money to lend today.  Therefore if the interest rate for long term bonds goes up, then all interest rates rise.

There’s a couple problems I have with this.  First, it assumes that interest rates on U.S. bonds are going to rise.  I’m not entirely convinced of that yet.  First of all, the Federal Reserve can still flood the market with cash by buying U.S. treasuries as they have been.  Second, if the government guarantees that all bonds will eventually be honored, there’s no reason to believe that the overall price is going to go up.

On the other hand, maybe interest rates will rise.  I’ve learned to never underestimate the irrationality of the financial markets.  Also, if the credit rating agencies like Moody’s and the S&P actually downgrade U.S. bonds (another irrational move, if you ask me), there could be a rash of sell offs as pension plans and etc have to sell them off because they are required to have a certain amount of highly rated bonds.  If that happens, that’s going to flood the market with U.S. bonds making them worth less and sellers would have to offer a higher interest rate to sell them – which then increases the interest rate.

My bottom line prediction for the U.S. bonds is that default will temporarily raise interest rates, but they will quickly fall again once the whole debt limit is settled.  How hi they rise will depend on the Fed’s action as well as if the credit rating agencies officially downgrade U.S. bonds.


The Purpose of Taxes

The story of taxation usually goes like this:  You earn your dollars, then give some portion of it to the government.  The government then takes your money and buys tanks, builds roads, and gives food to the poor.  For local and state governments, that is a true story.  However, for the federal government, which creates the currency, this story remains just that: A story.  Despite what most people in Washington believe, the government doesn’t need your tax dollars to fund it’s activities.  Since the federal government can create money at will, then how does it make sense to say that it needs your taxes to fund all the things that it does?  Obviously, it doesn’t.  So what is the purpose of taxation? The purpose is two-fold:  To control inflation and maintain demand for the currency.

Taxes are needed to regulate inflation.

Since you already know that government spending is constrained by inflation, not revenue, then this should make sense.  If everything else were to remain equal, then taxes would always have to rise with spending to regulate inflation.  If the government kept injecting large amounts of spending without taxation you would eventually see inflation.  However, there are several reasons that inflation and budget deficits don’t always correlate.

There are many reasons that they do not always correlate.  A high savings rate is a good example.  If people are saving dollars instead of buying items it can cause deflation.   Another is fluctuations in foreign exchange markets.  In fact, we are currently living in an age of astronomical budget deficits, and yet we are still seeing very low inflation.

The other reason for federal taxes is to maintain demand for the currency.

Once a currency has already been established, this reason isn’t as obvious.  To understand this concept you we must go back to the launch of a brand new currency.  Let’s say Ireland decided to dump the Euro and create a new currency called ‘quid’.  The Irish government would make a bunch of quid and then try to use it hire someone to sweep the streets of Dublin.  What they would find is that no one was willing to word for quids, no matter how many were offered because everyone would still be using Euros.

Ireland finds that it must artificially create a demand for quid.  They do this by declaring that all taxes must be paid in quid.  Suddenly, people need quid.  People are now willing to work for the government in exchange for quid.  They can make the quid they need to pay their taxes and then sell their excess quid to people who don’t work for the government, but must still pay their taxes in quid.  In exchange for their quid, the workers could get Euro’s(an example of a foreign exchange market) or goods and services(a plain old money transaction).  The amount of Euro’s and goods they get for their quid is negotiated by the market.  After a time the currency will take hold and the Irish government will find it can pay for anything it wants in quid.  As long as people MUST pay their taxes using quid, there will be a demand for quid.

Upon reading this I hope that you come away with a better idea of what taxes are really used for.  Most people believe that the federal government must tax people to fund itself.  When you point out that’s silly because the government can create money at will, many people will start to think you’re suggesting doing away with all taxation(which would be equally silly).  That’s why it’s important to know and to explain to others the purpose of taxes:  Regulate inflation, and maintain the currency.

The Debt Limit is Obsolete

As I discussed yesterday, the debt limit is the congressional limitation on the amount of bonds that the U.S. treasury can have outstanding at a given time.  Two significant things happened in the 1970s that made the debt limit obsolete.  One is the Congressional Budget and Impoundment Control Act of 1974.  It formalized the budget process for the president and congress.  And even though it’s been amending several times, the current budget process still uses the same blueprint.  Also, the United States went completely off the gold standard in 1971.

At the time when it was first created, having a debt ceiling made sense.  It put a check on the executive branch to keep it from spending and borrowing without regard to congress.  It also protected our Gold Reserves from being over leveraged.  Gold Reserves were extremely important because we were (for the most part) on a gold standard so that the dollar could maintain value at home and overseas.  These two reasons for maintaining a debt limit no longer applies.

The Congressional Budget and Impoundment Control Act of 1974 created a new check on executive power.  It laid out a formal budgeting process that must be passed by congress every year.  Otherwise, the government must “shutdown” until congress acts to re-instate it.  Also, by statute, the President could no longer refuse to use or try to shift unused funds from one area of government to another.  Funds allocated by congress to build a road must be used to build that road or the President and executive branch would be committing a crime.  This budget process provides sufficient check on the executive branch from trying to (legally or “semi-legally”) re-allocate congressional funds.

In 1971, the United States went off the Gold Standard and never looked back.  Unlike past times when the U.S. went off the gold standard, it wasn’t temporary.  While there is a group advocating to go back to the gold standard, it’s small and doesn’t have a lot of momentum behind it.  For all points and purposes we are no longer on the gold standard and won’t be going back.  So what this means is that o matter how many dollars are issued by congress, treasury, or the Fed, they cannot be redeemed for anything but more dollars.  While that has several implications, but none of them is the possibility of any bank losing gold reserves.

So what does it all add up to?  The debt limit has lost its usefulness.  The only purpose it serves is one more thing congress has to do when budget deficits increase.  You might say it offers a chance to get the public and congress to face large budget deficits.  However, that already happens every year thanks to the yearly budget process.

Congress should “raise” the debt limit one last time, but instead of raising it just eliminate it.  If removing it does create a problem, congress can always add it back.

What is the U.S. debt ceiling?

The U.S. debt ceiling  is, as this CNN Money article describes it, “The legal cap on how much the government can borrow”.  That’s what it means in layman’s terms, but where does it come from?  Why does it exist?  How can it be changed?

The phrase “debt ceiling” appears to be a media created term.   Technically it’s called the “debt limit” in the U.S. Code of laws.  It can be found in Title 31, Subtitle III, Chapter 31, Subchapter I, subsection 3101, paragraph (b):

The face amount of obligations issued under this chapter and the face amount of obligations whose principal and interest are guaranteed by the United States Government (except guaranteed obligations held by the Secretary of the Treasury) may not be more than $11,315,000,000,000, outstanding at one time, subject to changes periodically made in that amount as provided by law through the congressional budget process described in Rule XLIX of the Rules of the House of Representatives or otherwise.

You’ll note that the amount listed in U.S. code doesn’t match what the current limit actually is.  Modification of U.S. code hasn’t been updated to reflect the last time the debt ceiling was raised.

What’s interesting is that even though the united states has been consistently in debt since it’s inception, the concept of a debt ceiling didn’t come about until 1917 during World War I, but the birth of any overall limit on all public deb didn’t come about until World War II.  A paper prepared by the congressional research service gives a brief history.

The statutory limit on federal debt began with the Second Liberty Bond Act of 1917,10 which helped finance the United States’ entry into World War I.11 By allowing the Treasury to issue long-term Liberty Bonds, which were marketed to the public at large, the federal government held down its interest costs.

Before World War I, Congress authorized specific loans, such as the Panama Canal loan, or allowed the Treasury to issue specific types of debt instruments, such as certificates of indebtedness, bills, notes and bonds. In other cases, Congress provided the Treasury with limited discretion to choose debt instruments. With the passage of the Second Liberty Bond Act, Congress enacted aggregate constraints on certificates of indebtedness and on bonds that allowed the Treasury greater ability to respond to changing conditions and more flexibility in financial management. Debt limit legislation in the following two decades also set separate limits for different categories of  debt, such as bills, certificates, and bonds.

In 1939, Congress eliminated separate limits on bonds and on other types of debt, which created the first aggregate limit that covered nearly all public debt.  This measure gave the Treasury freer rein to manage the federal debt as it saw fit. Thus, the Treasury could issue debt instruments with maturities that would reduce interest costs and minimize financial risks stemming from future interest rate changes.16 On the other hand, although the Treasury was delegated greater independence of action, the debt limit on the eve of World War II was much closer to total federal debt than it had been at the end of World War I. For example, the 1919 Victory Liberty Bond Act (P.L. 65-328) raised the maximum allowable federal debt to $43 billion, far above the $25.5 billion in total federal debt at the end of FY1919.   By contrast, the debt limit in 1939 was $45 billion, only about 10% above the $40.4 billion total federal debt of that time.

Since WWII the debt limit has been raised dozens of times.  Whenever it changes, it has to either temporarily or permanently change the section of U.S. Code that defines the debt limit.  In fact, if you scroll to the bottom of the subsection I link to, you’ll see a list of how many times the code has been amended.  So what is the point of the debt limit?  Originally it was to have some kind of cap on the U.S. treasury department, but also give it the ability to get the lowest possible interest rates using whichever debt instruments it wanted.

So the debt limit was there just to keep the treasury from borrowing, (and the president from spending), whatever it wanted without any congressional say.  It also freed congress from having to approve every single bond sale.  Until the Budget Control Act, it was the only self-imposed limit on federal spending.