Asset management

7 October 2013

Economist Insights Dancing on the ceiling

The US Congress has passed one law (the debt ceiling) that is in direct contradiction with another law (the budget or continuing resolution) leaving the executive branch with a dilemma. If Congress fails to extend the debt ceiling, it will force the Treasury to either break the budget law by not spending what it is meant to spend, or break the debt ceiling law and issue more debt. Paradoxically, hitting the debt ceiling could be better in the long run (if the debt ceiling is then challenged in the Supreme Court) by removing the debt ceiling as a political weapon once and for all. If the debt ceiling is raised, we know that Congress will just be dancing with disaster again in the future. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

The terms debt ceiling and debt limit are actually rather misleading. They imply a restriction that stops borrowing happening, but in fact simply refer to an enabling law which allows borrowing to happen. Prior to 1917, when the first debt limit was introduced, the US Treasury had to ask permission for every Treasury note, T-bill or loan it needed to issue. This was a laborious process, so a general permission was introduced that enabled the Treasury to issue debt up to a pre-set limit. It was a bit like granting the Treasury a limit on its credit card rather than having to come back each time revenues fell short of expenditures. In short, the debt limit is not a way to control spending, but rather a way to allow financing. Commentators often talk about the fact that Congress has raised the debt ceiling 78 times since 1960 as if this shows that the limit was a failure because it did not constrain debt. This is missing the point entirely. Many outside the US, and even inside the country, overestimate how much power the US President has. It is Congress that controls the purse strings: as the legislative branch, Congress decides what taxes can be levied and what expenditures can be made. The executive branch, headed by the President, is then responsible for collecting the taxes and spending the money as authorised by Congress budget. When spending is higher than revenue, the Treasury needs to borrow. For 2013, the Treasury has been instructed to spend USD 3.5 trillion and revenues are expected at USD 2.8 trillion. This would mean borrowing of around USD 0.64 trillion (depending on how revenues come in). The existing debt ceiling is too low to allow for that much borrowing. Since Congress has passed one law (the debt ceiling) that is in direct contradiction with another law that it passed (the budget or continuing resolution), the executive branch faces a constitutional as well as practical dilemma.

Other countries avoid this problem by ignoring the whole concept of a debt ceiling: since revenues and expenditure are set by the budget then let the Treasury borrow as much as is needed to balance the two. Denmark (alone in Europe) has a debt ceiling but gets around it by setting the ceiling so high that it would never make a difference. In 1975 Congress introduced a sensible and logical approach by legislating that the debt limit automatically increased in line with the budget. In 1995 the Republican-controlled House of Representatives voted to scrap that law and ever since then the debt ceiling has become a political weapon. If the debt ceiling is a weapon, then it is one that is liable to explode in the users face. If the debt ceiling is not raised in time, there is the possibility that the US could be forced into a technical default technical because interest payments or redemptions would be missed but investors still believe that they would be repaid once Congress sorted the mess out. Nonetheless, the financial and economic effects of even a technical default could be devastating. Ignoring for the moment all the high profile aspects of finance such as mergers, share issuance and the like, the less glamorous part of finance involves more mundane borrowing and lending for short periods of time. You can think of this as the plumbing of the financial system: not very exciting but you really want it to work properly. Much of that borrowing involves a borrower providing a security as collateral for a loan, and much of that collateral is composed of US Treasuries and T-bills. If these securities are called into question by a technical default they may no longer be accepted as collateral. To extend the analogy, there would no longer be any water in the plumbing of the financial system. The last time that this kind of systemic shock hit the financial system was after Lehman Brothers collapsed five years ago.

We are still experiencing the damaging impacts of that event on the economy. When the 17 October deadline is hit, will the US default on its debt that day? Maybe, maybe not. The Treasury will have USD 30 billion of cash on that day, and if revenues come in like they did last year then there could be enough to cover expenditures for a few more days. As far as Treasuries are concerned, the first interest payment is on 31 October (see chart). As long as the market is willing to roll over T-bills in the interim then a default on government securities can be delayed until the end of the month. Other payments would stop earlier, including a sizeable social security payment due on 23 October.
Ceiling caving in Scenario for US cumulative daily expenditure and revenue flows 400 350 300 250 200 150 100 50 0 Thu 17 Oct Daily average Thu 24 Oct Thu 31 Oct Thu 7 Nov Interest Thu 14 Nov Revenues

Treasury can free up some cash flow, at least in the short run. This would still be a type of default and would be very painful for the employees and companies involved, but has the advantage that it would not be a systemic shock. Cut spending. Much like the government shutdown, the government could choose to cut spending. But this is austerity by accident and eventually the effects would add up to a further tightening of over 4% of GDP over the year. That would spell deep recession. Capitulate. The Democrats could grant enough concessions to the Republicans to convince them to raise the debt ceiling. This may keep the markets happy for now, but it will just encourage politicians to keep using the debt ceiling as a weapon again and again. Ironically, it would make the US a riskier credit. Constitutional approach. Hitting the debt ceiling would not only force the executive to break at least one Congressional law, but it could also break Constitutional law. The fourteenth amendment to the Constitution requires that the validity of the governments debts shall not be called into question. This does not just mean Treasuries; defaulting on salaries of employees or monies owed to suppliers would also qualify as a debt. This suggests that the only course open to the executive is to ignore the debt ceiling, keep issuing debt and ask the Supreme Court to rule that the debt ceiling would breach the Constitution. For some unfathomable reason President Obama ruled out this approach at the last debt ceiling impasse in 2011. Game theory suggests it would be irrational for the Republicans to force a shutdown, and if the Constitutional approach is legitimate then it would be irrational for the Democrats to offer any concessions. Clearly some in the Republican party might be willing to let the debt ceiling be hit, but rumours are already circulating that the more moderate Republicans would be willing to join Democrats for a vote to raise the debt ceiling. Paradoxically, hitting the debt ceiling could be better in the long run, provided that the Constitutional approach is taken and the Supreme Court rules that the debt ceiling is not binding (only the Budget is binding). This would remove the debt ceiling as a political weapon once and for all and actually improve the creditworthiness of the US. In contrast, if the debt ceiling is raised, or even worse raised for only a few months, we know that Congress will be dancing with disaster again and again. Eventually that could make investors question whether the US dollar really deserves to be used as the worlds reserve currency.

Social security, military

Source: CBO, Treasury Department, UBS Global Asset Management Note: Revenues are assumed to be the same as for the same dates last year, scaled up by the increase in revenues over the last 12 months relative to the prior 12 months

If Congress fails to extend the debt ceiling, it will force the executive branch to break the law. The Treasury can either break the budget law by not spending what it is meant to spend, or it can break the law and issue more debt. What are the options available to the executive branch and the President as head of the executive? Default on debt. As debt falls due the government would hope to roll over the debt; for example, a maturing T-bill could be repaid by issuing another T-bill. If this is not possible, it may be forced to default. Even if debt is rolled over, it could still default on interest payments. Default on payments. In the course of its actions the Federal government builds up obligations: employees must be paid at the end of the month, invoices for goods supplied and services rendered are due a certain number of days after they are delivered. By falling late on these payments the

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