Don’t crack the Treasury market while trying to save it

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Stephen Miran and Dan Katz are co-founders of Amberwave Partners, an asset management firm, and served as senior advisers to the US Treasury from 2020 to 2021. Stephen is also an adjunct fellow of the Manhattan Institute.

The US government could run out of money to finance its budgeted spending as early as next week if negotiators’ latest push for a debt limit deal fails. Given the proximity to X-Date and the unpredictable consequences of a default, it is worth revisiting the options to deal with the impasse.

The first and most direct path is what negotiators are currently working towards: a bipartisan agreement that would raise the debt ceiling in exchange for future fiscal restrictions. Such an agreement is the only good choice, in our opinion. With core inflation running north of 5% and a minimum of six decades in the unemployment ratethere’s never been a better time to tighten your belt.

If Congress does not increase the debt limit, the second option comes into play: so-called payment priority, in which the government will stop issuing new debt, finance spending from tax revenues, and choose which appropriations to meet until a agreement.

The Fourteenth Amendment to the Constitution provides that “the validity of the public debt of the United States . . . it will not be questioned.” THE correct interpretation of this clause, such as the Supreme Court held at Perry versus the United States, is that the Constitution prohibits the federal government from defaulting on its debt. Government service charges are mandated by law, but debt service is constitutionally privileged above them.

Likewise, other categories of allocated spending would have priority under the President’s constitutional obligations. In our view, payments for services rendered to the government by individuals and businesses will be given priority as a legal matter; are similar to the “public debt”, with a contractual counterparty with the right of ownership in payment. Legally, transfer payments would fall further down the priority scale. This is consistent with Supreme Court jurisprudence, including its participation Flemming versus Nestor that social security payments are not contractual obligations. This is why Congress can freely increase and decrease Social Security benefits and other transfers.

These across-the-board cuts would spell severe economic pain for disbursements like the elderly, and are exactly why Congress should reach a bipartisan agreement on a sensibly designed tax package and raise the debt ceiling.

But they would be preferable to the third option: unilateral White House action to avoid the debt ceiling and finance all budgeted spending. While these unilateral measures might be able to avoid an immediate spending cut, they would end up severely damaging the bond market.

While the above interpretation of the Fourteenth Amendment establishes payment priority as a natural consequence of the debt ceiling, there is a more alarming interpretation than that of the Biden administration reported considering keep spending non-stop. Under this topic, the “debts” addressed by the Fourteenth Amendment are not just Treasury obligations, but all federal government obligations, including Social Security and all other expenditures appropriated by Congress. This would allow the Biden administration to continue issuing more Treasuries on the grounds that the debt limit itself is unconstitutional.

Legally, this approach is highly doubtful. Section Four of the Fourteenth Amendment references “claims” and “obligations” separately, but specifically lists only “national debt” as that which is not to be questioned.

There is another problem with this proposal: the potential downfall of the Treasury market.

The legal status of Treasuries issued in excess of the debt limit to finance spending would immediately be called into question and they would trade at a discount to older Treasuries due to the uncertainty. Such a discount could only be closed by an unequivocal legal statement that the new debt shares the same full trust and credit as the old securities. Furthermore, the existence of such a discount may itself provide legitimacy to challenge the legal basis of the new debt, as holders of newly issued debt may suffer losses due to their questionable legal status.

A two-tier Treasury market would raise serious questions: What class of Treasuries would you be looking for policy rates on? Can commercial and technological networks manage a bifurcated market?

What is certain is that a segmented bond market would undermine the ability of Treasuries to act as risk-free collateral in support of the global financial system. Segmented sovereign bond markets are the kind of chaos one could see in the event of a default emerging market countriesnot in the world reserve currency source.

There are some potentially more legally permissible ways to buy more time, such as buying back discounted bonds or issuing prize OR consular obligations, as the debt limit applies to the face value and not the market value of the debt. But given the limited supply of discount bonds and limited markets for premium bonds, zero coupon bonds and perpetuals, there won’t be enough liquidity for this to be a long-term solution. The debt ceiling therefore remains a binding constraint.

Another more radical path is to mint A “trillion dollar coin.” This proposed solution, a favorite of the modern monetary theory crowd, argues that the Coinage Act allows the Treasury to strike a platinum coin in any denomination and for any purpose and deposit it with the Federal Reserve. By minting a huge infusion of money, the Treasury would not need to borrow to finance government expenditures, meet the debt limit.

Bondholders would price the expectation of being repaid in future currency rather than taxes, meaning they would ask for a steep dollar discount, undermining the Fed’s efforts to stem inflation. The money supply will also expand permanently, pushing inflation higher, as government spending will be financed by money rather than taxation and debt issuance, the latter of which represents future taxation. If the Fed did it sterilize this increase in the money supply by selling its securities holdings, it would still quickly send higher interest rates, as a result of the incremental supply of Treasuries coming to market. Furthermore, the money farce would destroy the basic economic assumptions about the independence of the Fed.

What these unilateral approaches have in common is that, in order to save the Treasury market from the debt limit, they destroy it in other, more creative ways. Maybe that’s why Treasury Secretary Yellen repeatedly he refuses to approve them.