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Everyone keeps repeating that hitting the debt limit would necessitate a default on principal and interest. The Treasury itself says
Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations – an unprecedented event in American history. That would precipitate another financial crisis and threaten the jobs and savings of everyday Americans – putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession.
The first statement is correct. The second is not. The government is still hauling in tax revenues. The Treasury could easily say "given the catastrophe that a default would produce, we will always pay interest and principal on treasury debt before any other payment." Congress could pass a law stating that fact. There is no economic reason that a debt limit should force a default.
There is a legal argument, and a claim that the Treasury cannot prioritize debt payments over other legally mandated payments. In the research I've been able to do however, this is a very uncertain claim. And it makes no sense. The Treasury is legally obligated to make debt payments, as it is obligated to pay Social Security checks, and also legally obligated not to borrow. Law prescribes the impossible. It has to prioritize. Indeed, unpaid bills are a form of debt, so if you want to be a stickler, the government will violate the debt limit no matter what it does.
The second statement is false. The US has defaulted on gold clauses in the 1930s. It has defaulted on other "legal obligations."
The third is correct, and appropriate. If we are to tussle over paying Wall Street fat cats vs. grandma's social security, keep in mind just what a catastrophe default would be. Grandma will be way worse off if that happens. Treasury debt is now the golden collateral, supporting most of the financial system. (We should have a financial system much less dependent on short term collateralized borrowing, but that's another story.) If in default it would not be. Worse, and most important here, if financial markets suspect a default will really happen, they will start refusing to accept treasury collateral in the first place. This is basically what happened in 2008 with mortgage backed securities. They didn't fall to pieces, they just weren't acceptable as collateral any more.
A flight from treasury collateral under a debt limit would be far worse. And the government's magic tonic, borrow a ton and bail everyone out, would be unavailable.
Perhaps Treasury thinks that by threatening default, they can get Congress to wake up and raise the debt limit promptly. But this risks Wall Street also believing the threat and causing the panic you're trying to prevent.
Treasury secretary Janet Yellen should say out loud, right now "we pay principal and interest on treasury debt first, before anything else." President Biden should back her up. Drastic delays in social security, medicine, government shutdown and more are plenty enough threat to get Congress to move, without risking a run.
States with balanced budget rules are interesting legal precedent. The State of Illinois, while I was watching, simply delayed payments, often by years. It paid its bonds on time. That isn't a good outcome of course, but it represents the State's choice of how to handle the legal requirement to pay vendors and to pay interest and principal on bonds. Other states have defaulted as have cities and counties. And countries.
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Now for fun. Just print money, some say. Fortunately, our legal system is full of mechanisms to prevent the government from printing money instead of borrowing it. The treasury has to issue debt; the Fed has to buy it, and thereby give the Treasury new money to spend. That violates the debt limit. But Treasury can create coins. So, last time, the fun suggestion of $1 trillion dollar coins came up.
Here is a novel proposal in the same sprit. The debt limit is calculated based on face value, not market value of debt. A bond promising $100 in 10 years and $3 coupons from now to then counts as $100 of debt. So issue perpetuities. Or, more realistically, issue coupon only debt. The government could issue a bond that pays a $3 coupon for 30 years and no principal payment. As things are now calculated, that bond adds zero to the debt!
Like the trillion dollar coin, this proposal so clearly violates the spirit of the debt limit that I doubt serious people would do it. It does point to a serious shortcoming in how the Treasury calculates debt however. Most of the time Treasury issues debt at par, borrowing $100 and promising to repay $100 in 10 years. Then the distinction does not matter. But the formulas should be fixed.
Disclaimer: I'm not an expert on the law of the debt limit. If these points are in error, let me know and I'll issue a "never mind."
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To clarify, this is just a fun way to get around the debt limit if one wants a fun way to do it. It's not obvious that getting around the debt limit is a good idea. What is the justification for running primary deficits right now? No, I'm not a balanced budget nut. In times of crisis, war, pandemic, and recession, the government should borrow, for standard tax-smoothing reasons. But then the government should repay the debt. When the economy is humming and there is no crisis on, we should be running small steady primary surpluses. That is now. One has to argue that yes, we should get there, and stop borrowing in good times, but it's too hard to do all of a sudden. But just what are those adjustment costs? A crisis is a terrible thing to waste. Today is as good a day as any to clean up the US long term fiscal mess. It's not clear to me that Washington does anything better if it takes a long time to do it.
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