The US is in the middle of another debt ceiling fight. The expectation is that it will get lifted before we hit the so called "drop dead" date — but what happens if Congress does not authorize more debt financing? What are the options for the government? Does this automatically lead to default? And if the US does default on its debt, what does that mean for the financial system and the real economy? On this episode of the Odd Lots podcast, we speak with George Pearkes, macro strategist at Bespoke Investment Group, about how the debt limit actually works, and we attempt to get an understanding of what to expect if we reach this uncharted territory. This transcript has been lightly edited for clarity.
Key insights from the pod:
What is the debt ceiling anyway and when do we hit it? — 2:25
The role of the debt ceiling in US politics — 4:20
Prioritization of payments and general default — 9:33
Impact on the repo market and technical systems — 17:34
Who gets to decide payment prioritization? — 21:39
Can the president ignore Congress and the debt ceiling? — 25:00
Selling high coupon bonds to avoid default — 29:04
Technocrat versus political solutions to issuing debt — 33:12
Impact of extraordinary measures/TGA balances on liquidity — 37:07
Market volatility and political pressure — 42:33
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Tracy Alloway: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
Joe. Debt Ceiling.
Joe: (00:18)
Oh, I'm so excited. We're doing a trillion dollar coin episode.
Tracy: (00:21)
I knew, I knew you were going to say that.
Joe: (00:25)
I just said that to annoy you.
Tracy: (00:25)
To annoy me, yes. This is not an episode on the trillion dollar coin. If you are interested in that particular piece of finance thought experiment, you can check out our previous episode on the topic. I think it was over an hour long -- all about trillion dollar coin. Yeah. Okay. Check out that episode if you want to talk about the trillion dollar coin. But today we're going to be discussing something slightly different. We are going to be talking about what exactly happens if the US actually does default,
Joe: (00:58)
Right. Because I think there's just a lot of uncertainty about this question of, okay, look what happens if they don't raise the debt ceiling? And what are the constraints? What are the various things that could happen? How bad would it be if we actually didn't pay the debt? Does the White House have ability to pay some debt, but not others? It's pretty uncertain. It seems bad, right? Like it is layman defaulting was bad. Russia defaulting in 1998 was bad. And Russia is like this, like tiny, you know, the how big was Russia? That nothing. So like
Tracy: (01:33)
It is a moving feast of uncertainty. Like a twirling whirlwind of chaos and uncertainty and open questions over exactly what happens. And there are all these moving parts. I think we really need to sit down and discuss them and kind of talk about it in an almost sequential way. Like, this is what happens if this happens, and then that happens. So we really do have the perfect guest for this. We are going to be speaking with George Pearkes, an Odd Lots favorite. Of course, he is also global macro strategist over at Bespoke Investment Group. So George, thank you so much for coming back on Odd Lots!
George Pearkes: (02:10)
Hey all. Thanks for having me.
Tracy: (02:12)
Let's start with the basics, since we're talking about this as a sort of primer episode on the debt ceiling and the debt limit. When we talk about limits on US debt, what do we mean exactly?
George: (02:25)
So the US is really unique in a very frustrating way in that not only do we have restraints on spending in terms of Congress authorizing and the president signing into law bills that create government spending, and then appropriations processes after that, you know, throughout the year, we also have this brake on the total amount of debt that can be issued.
So Congress can at the same time instruct the government bureaucracies to go out and spend money, but at the same time say, ‘oh, well you can't actually issue debt to do that spending. We've told you to do. And oh, by the way, you can't collect any more in taxes because we also control that and we've told you the amount you can collect in taxes.’ So it's this contradiction, in terms of instructions to the executive branch and to various federal government bureaucracies from Congress and from the president.
And it's a thing that's been around in US politics for a long time. But, you know, I think the most important thing to understand about it is that it's just, it's nonsensical. It doesn't make sense for there to be this extra restraint on top of the existing safeguards against, you know, in a representative democracy where people are elected and then they authorize the spending on behalf of the population. We also have this thing where there's a debt limit that serves as sort of a secondary veto point on government spending.
Joe: (03:46)
Defenders of the debt ceiling law would say, ‘look, that's kind of true, but it is good to have this debate every couple of years about our level of indebtedness. This can be used as a brake of sorts for constraining spending.’ In the 2011 debt ceiling fight, there really were cuts and the cuts to the growth of federal spending. You know, you're saying, ‘okay, this is sort of a maddening law, makes no sense.’ Does the debt ceiling have a history of being used to sort of regroup and retrain our thoughts about how much we're spending?
George: (04:20)
The short answer is no. I think that the more consistent way to think about it historically is that it's used by one faction or another in US politics, against whoever happens to sort of be the party in control. So, you know, this is a bipartisan thing. It's used both ways. Both parties have declined to get rid of the debt ceiling on a permanent basis when they've been in power.
So I don't mean to say that this is a red versus blue, you know, one side's an abuser of this versus the other. But what it does is it just, it creates a veto point and allows the legislative minority to extract what it wants from, or some of what it wants, from the legislative majority. Now, that's not necessarily the end of the world, but there are a couple things to think about here.
First, the US system of government is already full of veto points, right? Whether it's process of bills through committees, process of bills through the house, process of bills through the Senate, judicial checks on all that, the executive branch, the high requirement in the Senate to sign things in the law. There are some exceptions, but basically you need a super majority in the Senate to get things signed into law. So there's just, we have a replete number of veto points. Adding, you know, just one more - the benefits are pretty negligible. Even if you agree that that, you know, controlling the debt's size is a super important public policy goal. I don't happen to agree with that. But let's take that as given. Even then there are costs associated with this, that are very real and the cost is the credibility of the US’s ability to pay its debt on time in full.
And, you know, there are real questions about the United States Treasury's ability to settle out coupon and interest payments on debt, let alone payments to social security recipients, payments to government contractors, government employees, etc., etc. this year, because of this debt ceiling being present
And again, I think it's really important to emphasize debt ceiling being present, even though those payments, all those payments that are set to go out, all the spending, all the payments that are set to come into the Treasury in the form of taxes, all of that has already been approved by Congress. The debt ceiling is a secondary approvals process that has nothing to do with keeping, you know, a lid on spending in a direct sense.
Tracy: (06:20)
So George, you, you just set out the stakes kind of perfectly there, but talk to us, you also mentioned the Treasury, talk to us about extraordinary measures because the US Treasury has already said that it's started to take these extraordinary measures in order to meet its obligations because we have in fact already exceeded that $31.4 trillion, or whatever it is, borrowing limit. What are the extraordinary measures and how do they actually play out here?
George: (06:51)
So there are a variety of things that go into the extraordinary measures behind the scenes. I mean, the simplest way to think about it is changing timing of payments and sort of where there's flexibility to defer payments or to pay them, you know, without issuing debt. So wait for new payments to new tax payments to come in before sending out existing payments. That's one way to think about it.
The most important thing though is spending down the balance that's recorded in the Treasury general account at the Federal Reserve. So the Federal Reserve is the United States Treasury's fiscal agent, which basically means that that payments are being made via the Fed. So if you are the Treasury, you don't have a checking account at a private bank, you have a checking account at the Fed. There are ways in which the government is nothing like a household, but in terms of access to a checking account, that is one way the government is like a household.
There is an account at the Fed, again called the Treasury general account that is essentially a cash balance, a balance available for payments that is used to settle payments owed by the Treasury to other individuals or entities throughout the economy. And what the Treasury has been able to do since 2015, well, they’ve been able to do it beforehand. But what if they've done, as a matter of course, since 2015 is build up this Treasury general account in the period leading up to debt ceiling limits being reached, because that allows for flexibility over the subsequent months.
Basically, if you know that you're going to be without a paycheck for a couple months, you save some cash away in your checking account, you're not going to buy a long-term investment with it because you know you'll need it, but you'll have a little balance in your checking account and then when your paycheck doesn't come through, you can still pay your rent for a couple months.
You can't do it indefinitely, but you have this sort of cushion there. And that's sort of what the Treasury general account spend down is. And that's the core of extraordinary measures that allows the Treasury to continue to make all the payments it's mandated to by law, you know, whether that's payments to contractors, payments to employees, payments to beneficiaries, whatever payments to holders of the national debt, all those can continue to go out the door as normal in part because there's this cash balance at the TGA that's being spent down.
Joe: (08:58)
Okay. We have these sort of, they're called extraordinary measures, but they're not that weird, they're more like, you know, short-term cash management techniques that allow the government to make its obligations for a few extra months. Let's talk about, okay, when those run out, what happens? Where do things stand? What is your estimate for when the sort of real debt limit [runs out] when we no longer have these sort of
Tracy: (9:27)
The drop dead date.
Joe: (9:29)
Yeah, the X date, the drop dead date. Talk about like what happens as we get closer to that.
George: (09:33)
So I personally don't think my estimate is any better than what we've heard from Secretary Treasury Yellen. She says June 5th is sort of her best estimate, but it's important to understand that she described it as having considerable uncertainty. So for instance, if we have a really, really strong tax collection season or really, really weak tax collection season over the next three months, that's going to have big implications for the timing here, right? Just because a huge percentage of cash flows in and out of the Treasury take place over tax season. So, you know, there's just all sorts of uncertainties. Also private sector visibility is not great into all the timing of payments and their size. So I'll just make that caveat. You know, I think sometime in May/June is probably the right way to think about it.
Late May, early June, we'll hit this drop dead date where essentially there are more payments being requested from the Treasury than there is cash balance plus payments being made to the Treasury. And at that point, I think it's important to stress that we don't actually know what's going to happen. Nobody knows. There may be Treasury bureaucrats somewhere that know. But for all intents and purposes, they're not saying anything.
And we can't really be sure, I think the most popular in terms of like people saying, ‘well, why don't you just do this option?’ is something called prioritization, which is to make some payments and not others. So what does that look like? For instance, if the Treasury sees that they have a payment due to the holder of a long-termTreasury bond, they will make that coupon payment, but they won't necessarily make a payment to, for instance, employees of the federal government for their paycheck.
How you assign a matrix of sort of who gets paid and who doesn't get paid in that scenario is a super fraught political question that deserves a lot of discussion. It's all hypothetical because the Treasury has said, ‘well, we can't actually do this. We don't have the technical abilities to do this.’ Now they may be bluffing when they say that – [that’s] one way to sort of get a better outcome around the debt ceiling from the Treasury's perspective, because if you're the bureaucrats of the Treasury, what you care about is just being able to do what Congress has told you to do in terms of making payments in and out of the Treasury general account. You don't really care about the political fight. You just want to do your job.
And from that perspective, Treasury has signaled quite aggressively, ‘look, we cannot do prioritization. So if we hit the X date, then we're not going to be able to say, oh, make this payment, but not that payment.’ Whether that's true or whether that's sort of signaling in a game that makes default very, very costly for whoever lets it happen is an unclear thing. Like one possible explanation is that Treasury is saying that as a way to signal to, for instance, Congressional Republicans that, ‘hey, y'all can't do this, or it's going to be really, really bad.’
If Treasury is being honest around prioritization, and again, I don't have any insight into, you know, I don't have a way to say like, ‘oh, they're not being honest,’ but it's definitely possible that they're sort of presenting a reality that's a little bit less the case than it really is, but assuming they're being honest, then when Treasury runs out of cash, you come to this second scenario called a general default.
And that is basically saying we're not going to make any payments to anybody because everyone's on an equal footing. We can't tell payments apart and we are just not going to make payments until the debt ceiling is lifted. That would be enormously disruptive and would obviously involve an outright default on certain US securities. There would probably be make wholes, but there would be a default. There would also be a default on everything from social security checks to government employee paychecks. The military wouldn't get paid, military contractors wouldn't get paid, any government contractor wouldn't get paid cash out of the Treasury would entirely stop.
So I think in terms of the first two options around what the Treasury can do in terms of making payments, like levers they can pull in terms of making payments, those are the two extremes. Absolute prioritization would be they have this matrix of different priorities and they make them as they're able to, and some people don't get the payments they’re owed, but Treasury's able to finely tune that to like reflect what they want to do. That's one spectrum. And the other spectrum is general default. Nobody gets anything until the debt ceiling gets lifted.
Tracy: (13:38)
So obviously general default of the US sounds very, very bad and dire, but one of the things we've seen in previous debt ceiling dramas is that as we get closer and closer to that prospect, we tend to see market participants buying US government debt as a sort of flight to safety play. So what would it mean for the actual Treasury market, if we got to that general default point, what would you expect to see?
George: (14:08)
Well, that is where things get really fun because, you have two sort of competing…
Tracy: (14:12)
Definitions of fund may vary on Odd Lots.
Joe: (14:15)
Definitions of fun may not apply to the non-Odd Lots universe. Okay, keep going.
George: (14:19)
Exactly. So on the one hand, any missed payment on something that is assumed as just a general functioning bedrock principle of financial markets to never miss payments, whether it's principle or coupon, having a missed payment on that creates all sorts of headaches. Not only are you maybe creating forced sellers of people who are not allowed to hold securities that have defaulted -- and we can come back to that later -- but let's assume that there's some segment in the market that says ‘we're not allowed to hold these, or we just can't be seen holding these, so we have to sell them.’
On the other hand, some segment of the market would say, ‘look, this is a political fight. It's not a lack of ability to pay, it's a lack of willingness to pay that's going to be temporary. So we will accept some trivial risk premium to hold these securities because at some point we trust that we're going to be made whole, you know, we might lose a little bit, but you know, we're going to be paid something for holding these defaulted securities in the meantime. So we'll hold onto those.’
So figuring out who has these securities, who has to sell them, who wants to sell them, what prices the people who want to sell them are willing to trade at, versus the other side of the demand for these defaulted securities by people with a little bit looser risk tolerance, that's going to be a really… There's going to be a lot of volatility as those securities work themselves out.
There will be a series of bills around the debt ceiling maturity or around the debt ceiling X date that will be probably the most impacted relative to their historical volatility. Bills, remember, don't pay coupon payments. So you know, your whole payment of interest comes with the maturity of the bill. So, you know, as a percentage of your total cash flow for the instrument, bills are going to be a lot more impacted and they're also much less volatile historically. So, you know, if you see forced selling, you can see sort of more outside moves in what are typically much safer, less volatile securities.
On the other hand, you've got notes, bonds, notes and bonds, which are longer term. You know, if you're thinking about a 30-year bond, one missed coupon payment, that, you know, you probably get paid back in cash a month later doesn't really matter as much to the total value of the security. So it's plausible that you see long-term securities that miss coupon payments during that period outperform the front end of the yield curve, or you know, have their yields fall [and] prices go up in absolute terms because of general risk aversion.
Now there's also a scenario here where, and we're sort of getting far out into hypotheticals without really stressing what our metrics for this scenario are, but there's also a scenario here where basically there isn't much change in the Treasury market because the people who are willing to pay more and the people who are forced to sell or want to sell are relatively evenly matched and everything kind of just trades out at equilibrium levels. That's a very real possibility. Is it my expectation? Probably not, but it's something you have to think about.
Tracy: (17:05)
So one of the things that makes Treasuries special is that they are used for collateral in the repo market. So, you know, if you're loaning or borrowing a large amount of money, you will often use Treasury securities as your collateral/security in order to do that. What would be the impact on the repo market if you had doubts over whether or not some of these bonds are in default or are in fact going to be receiving their coupon payments on schedule?
George: (17:34)
I think it's probably best to think about the repo market as an extension of the cash Treasury market from that perspective. And in this scenario, I think there will be some repo market makers who are willing and able to take quote unquote ‘defaulted’ Treasuries as collateral and maybe apply some small haircut to them, but are willing to do it for a relatively small increase in their income from the activity. You know, just like there will be people who will be willing to pay, you know, slightly less than typical for a similar security because it's defaulted, but not, you know, half as much, you know, that kind of thing.
But we don't really know. The other thing, and I think this affects both the repo market and the cash market is we don't really know how well the backend settlement systems and trading systems are going to handle being able to trade something that's already past maturity, right? And hopefully their QA and dev people at banks and at funds and at other providers who are thinking about this and have tested this. But what happens if I have to buy on -- we're recording this February 9th -- what happens if I have to buy on February 9th a bill that has a maturity date associated with it of February 7th? Can the systems even accept that or does it throw an error and say, ‘no, you're not allowed to do that.
Joe: (18:46)
I'm so glad you brought this up because this is something I've wondered about exactly, which is that with most financial instruments when we're talking about default, you know, it's kind of an economic question, ‘well, what's there, when you're going to get your recovery, etc.’ And I've always wondered whether a US debt default, would it almost be more like the Y2K problem?
Tracy: (19:07)
See this is a crossover episode between ‘Why companies have terrible software’ and the US Treasury market.
Joe: (19:13)
This is exactly what I've wondered. Whether we're thinking about it, the risks in sort of the wrong dimension, whether it actually kind of creates all just sort of technical things. Like, here's the one instrument that no one ever thinks about missing a payment on, etc. It's like, you know, I don't know what the analogy would be, but I'm glad you brought this up because it seems like this could be the one thing where it's like, did they even like code the possibility that some of these instruments wouldn't get paid? And what kind of, I mean, it's kind of speculative, right? Hard to answer, but I'm glad you brought this up.
George: (19:47)
Yeah, I mean, I think the team over at Hindsight Capital would say, ‘well I sure hope they've been coding this because you know, we've known it's a possibility.’
Joe: (19:55)
Yeah. When are we going to get the CEO of Hindsight Capital on?
George: (19:57)
Every single trade, they're way ahead of things . But yeah, I mean we've known this as at least a hypothetical possibility since at least 2011. So you would hope, right, that there've been some efforts to make sure that settlement systems can handle this sort of thing. But just because you would hope that, doesn't mean you can actually say like, ‘oh yeah, that's how it would work.’
I know at some level there would be able to be settlement of Treasury securities that had defaulted. I mean, you can do stuff over the phone, you can do stuff with manual settlement procedures, but there's just no way that the market's going to be able to handle super high volumes if everyone's normal trading systems are just not working correctly because of, for instance, a maturity date that's prior to a settlement date, right? I think there would probably be just some disruptions there.
So, you know, that adds a liquidity dimension and, you know, liquidity being withdrawn, possibly due to issues in the software on top of the absolute risk premiums that people are willing to bear. And, you know, this all applies equally to repo too, you know, with repo, instead of thinking like, ‘oh, I want to buy or sell a bond,’ it's like, ‘oh, if I want to use this bond as collateral, can my system accept this as collateral if it's got a date that's later,’ you know, same, same principles basically.
So yeah, I don't know the answer to any of this to be clear. I used to work relatively close to bank settlement systems back at my prior role, but I haven't been near a bank settlement systems in almost a decade now. So, you know, I'm not sure anyone anywhere knows with great certainty what the aggregate trading community, whether it's fast money, real money, you know, what they can handle in this respect. But yeah, I don't know.
Joe: (21:39)
So I want to talk about another, you know, go back to this idea, or talk about this idea of, you hear ‘payment prioritization,’ and of course, as you mentioned, Treasury has insisted -- maybe they're bluffing -- that technically they don't have the capability to say shut off one kind of payments easily while say, making sure that we continue to pay debt. But setting aside the technical questions of whether they can do that, what about the political questions of who gets to decide what shuts down.
Because if you're Biden, it's like, okay, we're not going to pay the military and look, the Republicans are preventing the military -- our brave men and women -- from getting paid look. And then the Republicans might say, well, you didn't have to shut down military payment, etc. You could have done something less impactful, etc. But who gets to decide even a prioritization what does and doesn't get paid?
George: (22:29)
Yeah, totally. There are deep political questions about every facet of this whole problem. And I think it does illustrate so well how debt is a fundamentally political thing. I mean, we have our constitution because the first crack post-revolution at creating a structure for governance in the US, didn't handle debt well. Like, that's literally why we have the constitution we have today. Obviously there's more stuff in the constitution than just management of debt, but there is a general problem here where you are taking, what was the purview of Congress and elected representatives in assigning payments to various stakeholders that the Treasury faces on a settlement basis, and you're taking that away and you're handing it to Treasury with no explicit decision to do so.
If you are going to prioritize without legislation, and there will be no legislation on this, you know, then Treasury, unelected bureaucrats at Treasury, are just being told to make the best of it that they can and have fun figuring it out. That is not how a government's supposed to be run, right? I mean, that's not how a democracy's supposed to function. If Congress had wanted to delegate prioritization to Treasury and said that explicitly, that would be fine, whatever, that's their purview. But that's not what's going on here. It's Congress saying, ‘well, we're not going to do anything, so just do the best you can’ and throwing it back to Treasury.
And when you get that outcome, I mean, that's not going to be good for anybody regardless of who the winners and losers Treasury picks are, if they even have the ability to make those picks. It's a pretty deep irony that a representative democratic system is doing this to itself. And again, I want to emphasize that this is Congress doing it to itself. This is not an inherent thing around debt, you know, national debt management. This is a series of bad decisions that have been made by elected representatives over the past 30, 40 years that have gotten us to this point. And it's entirely a self-inflicted situation.
Tracy: (24:20)
I think this is such an important point to make -- this idea that debt is ultimately a social construct and inherently political in many ways. You know, it tells a story of who owes who what, and why. And so it's immediately caught up in, you know, the potential for different narratives. You mentioned how self defeating a lot of this tends to be in the US and it does seem, to put it mildl,y that defaulting on US debt would be bad. So what would happen if, you know, the executive branch just decided to ignore Congress on this? What if people just go off and, you know, the president goes off and does his own thing?
George: (25:00)
So earlier we were talking about, I mentioned how ‘fun’ it would be if we had a general default and what that would mean for the Treasury market. As for the Treasury market functioning fun, same thing for constitutional fun, in this instance that you just described.
So, just as a bit of background, if you read section four of the 14th Amendment, one of the key reconstruction amendments after the Civil War, there's a clause that says the validity of the public debt of the United States authorized by law, including debts incurred for payment of pensions and bounties for services and suppressing insurrection or rebellion, shall not be questioned. So this is just basically saying there's a general constitutional principle that if the United States government owes someone something, you can't get in the way of that, right? That’s the plain text reading of that.
How far do those powers go? It's an interesting question. No one's ever really litigated it. This clause, section four, was mentioned in litigation around a New Deal case, but it wasn’t really directly established to be read in a maximalist or minimalist way. Other parts of the 14th Amendment have been litigated to the end of time. I mean, it is one of the most litigated parts of the entire Constitution that the Supreme Court hears cases on, but this particular section has very little litigation associated with it.
So we don't really know what courts would do. But if you read that, that text just as, you know, sort of a plain text, then it seems to create a constitutional obligation to pay the public debt of the United States. And it's one thing to say, well, you know, we can't pay the public debt because we've run out of dollars.
But we know, you and I, Joe and Tracy, and hopefully Odd Lots listeners at this point, know that the Treasury creates dollars and the Federal Reserve creates dollars, and there's no lack of those dollars. You know, [we] can't run out of them. So that's not a restraint.
What then is preventing the federal government, or specifically the executive branch and the Treasury from going out and doing what the Constitution tells it to do by preventing people from questioning the debt and just saying, restraints on issuance of debt to make good on payments owed by the United States to third parties are unconstitutional. The debt ceiling is unconstitutional, and we're going to keep issuing debt to make payments until someone tells us to stop.
That path is one that is hard to see from a political group that has been as risk averse as the Biden administration has been. But I do think you can make a very good case that in an emergency, a situation where there's a general default where, you know, markets are crashing, where, you know, there's massive economic disruption, that this is a good choice to be made. That the debt ceiling is totally self-defeating. It's a red herring, it shouldn't exist in the first place. And by the way, there's a constitutional reading right here.
Now, I'm not a constitutional scholar, I'm not a constitutional lawyer. I'm none of those things. Like Jay-Z said, you know, I passed the bar, but I know a little bit, I know enough to know that this could hypothetically work, but that's about it. So I don't think I would predict that the Biden administration should or could go out and do this. But it is interesting to think about how these powers appear to be given to them by the Constitution, and that there could be a Supreme Court case settled based on whether the US has just issued bonds that are illegal under the Constitution. You know, again, fun.
Joe: (28:22)
So, okay, we're not going to have a coin conversation, but this does get to the other possibility, which is these technical workarounds that people believe exist in the law. So one possibility, one of these workarounds, could be invoking the 14th Amendment. And it seems pretty clear the history on that does not seem to be particularly ambiguous about why it's there. And it's kind of, you know, I'm reading on Congress.gov, [it’s] inspired by the desire to put beyond question the obligations for the government issued during the Civil War. And so, I don't know, it doesn't seem particularly ambiguous, but setting aside the 14th, talk to us about some of these other ideas in the law to avoid a default.
George: (29:04)
I think the easiest one to understand and easy by, you know, if you know a little bit of bond math, the easiest one to understand is this idea of issuing very high coupon bonds. So when we issue a bond, typically what happens is there's a bullet bond, that’s a standard term for what people think of as, you know, for instance, a Treasury bond where you get a series of payments over time that are called coupons that are regular small payments. And then you get a big payment at the end, which is called the principle, right?
Principle is, you know, typically you pay, you quote the price of a bond as the percentage of the principle payment that you will receive at the end. So for instance, if a bond is trading at 95, that means you pay $95 now, and then you get the series of coupon payments associated with that bond and the principal payment at the end, which is a hundred.
When Treasury auctions securities, they are sensitive to, they, they basically want to set the price of those securities just below 100 when they're first issued. They don't want to issue bonds at a premium. And they also have a series of other constraints, for instance, the minimum increment of coupon. So what they'll do is they'll issue bonds with a coupon that sets the principle payment, or sorry, sets the auction price just below a hundred when they issue. So for instance, they're not going to go out and issue a 15% coupon bond when the prevailing yield on Treasury securities is like 5%, right? They're never going to do that, but that's just like an internal norm that's not like written in law anywhere.
They don't have a legal obligation to do it that way. If they wanted to, they could go out and issue a bond that matures with a principal value of a hundred and pays coupon payments of a hundred, you know, a 100% per year for the next 30 years, say.
So let's say for instance, they did this, they said, ‘we're going to issue what's called a super high coupon bond.’ And again, this is nonsense territory from a pure finance perspective, but let's say they go out and that bond that matures 30 years from now at a face value of a hundred, it'll pay a hundred in coupons every year as opposed to, you know, a 4% coupon on the most recent issued 30-year bond, something like that.
So if you do the bond math on that, if you discount all those cash flows back to present value at the current prevailing interest rate, what you've got is an $1,800. You receive $1,800 today for the bond maturing at a hundred in the future. And the reason you get that is because it's got that long string of payments associated with it, with the same size as the principal payment.
You've basically issued a zero coupon strip all in one instrument for the next 30 years. And you've done that, the impact to the debt ceiling is a hundred, but you now have another 1700 in your pocket because of those coupon payments. Those coupon payments aren't covered by the debt ceiling. They're coupon payments, not principal payments, right? When Treasury counts debt, they're not counting the interest cost, they're counting the principal value. So that hundred dollars is, I mean, it's a technicality where you can say, ‘well, the coupon isn't principal, but it's still cash in my pocket now delivered at a later date that doesn't count against the debt ceiling.’
So, you know, that would be another technical workaround they could use. Again, this one is on much less dicey legal footing. There are lots of reasons why Treasury would maybe want to say, we don't want to do this. We don't have any interest in this, we're not able to do this. Whatever. There could be lots of reasons for that, but legally, it's not quite as dicey as saying to Congress in the Supreme Court, ‘well, we're just going to keep issuing debt and, you know, take your best shot at stopping us.’
Tracy: (32:37)
I'm trying to think what would be a harder sell to the public. Is it, you know, issuing a high coupon bond that like gets you immediate proceeds that are a lot more than the actual issuance amount? Or is it a large novelty coin?
Joe: (32:51)
Well, I mean, I was going to, you know, the novelty coin, I'm sure, well, we know what the headlines are going to be around that, but you know, at the same time, I'm imagining ‘Biden is borrowing at a hundred percent interest rates from China’ or ‘the payday loan.’ The headlines could go in either direction.
Tracy: (33:10)
Yeah, for sure.
George: (33:12)
Yeah. I mean, but then you have to explain how it's even possible to borrow at a hundred percent interest rates, or what is even happening there. I mean, I do think both the coin, for all its downsides -- Tracy, I know how much you love the coin -- but you know, the benefit of both the high coupon bond plan and the coin plan is that they're weird incantations, you know, run by technocrats.
They're not like a tangible thing where it’s like the US Constitution and this sort of feeling that the world is going astray. It's like, ‘oh, well they said the right words and everything's fixed now. So who cares,’ is how people tend to think about this stuff, I think, whereas when you were talking about the Supreme Court and the Constitution and Section four of the 14th Amendment and the history, and people get very up in arms or the constitution, you know, whatever. Whereas if it's just like, ‘oh, well we just said the right words magically to the bond market, now everything's fine.’ I think you get a very different, you know, feeling from that politically. But that's speculation on that part.
Joe: (34:11)
This is important, which is, okay, let's say the administration says, ‘You know what? The 14th Amendment says the debt ceiling is invalid, we're just going to ignore it and continue fiscal operations as normal.’ And then as you pointed out, there might be some ambiguity about whether the bonds issued after that moment are legal. And maybe there would be, we get to the Supreme Court and we don't really know what they are going to say, but to some extent this even applies to any other solution as well, including the high coupon bonds, including the coin, which is that someone could sue over the coin, like no one's going to stop it. And if like five out of the nine Supreme Court justices says, ‘You can't issue a hundred year bonds, that's clearly in violation of the spirit of the debt ceiling law, you know, you're still issuing debt at a time when we're not supposed to issue any more debt.’ The uncertainty exists in almost any of these scenarios
George: (35:02)
For sure. And , you know, we said it before, and I'll say it again, this is all a political question, a social question, right? Like political power means telling people to do something that they don't want to do. That is what political power is, right? And whether it's the Biden administration forcing issuance of new debt, whether it's the Supreme Court stepping in to either validate that or invalidate that, you know, that's the 14th Amendment scenario, or whether it's the Biden administration is saying, okay, we're not going to make any payments regardless of who doesn't get paid, or it's prioritization where some people get paid, for instance, bond holders maybe get paid, but you know, retirees don't.
Look, whatever approach you take to this, at some point someone is being told you don't get what you want because you can't stop me, you know, under our system, right? You physically can't stop me, or you know, enough of [the] other political bodies have sided with me so that you can't get done what you want to get done? And, you know, this is, at the end of the day, the debt ceiling has lots of interesting financial and economic and analytical things to explore, but it's always going to come back to being a political problem. It was created by politicians. It's being exacerbated by politicians and it will be solved through political means and nothing else.
And, you know, I'll always come back to that. I really, from that perspective, I cannot emphasize enough that Congress has created this problem for itself. And if there was justice, then Congress would lose power in some sense over this, whether it's the debt ceiling is invalidated by the Supreme Court or by the Biden administration or whatever. Or, you know, some other solution, unfortunately, the world doesn't work based on karmic justice. So I don't think we can hope that, ‘oh, well they, you know, Congress gets its comeuppance’, but maybe they will. I mean, we'll see. I mean, it's going to be an interesting few months here to say the least.
Tracy: (37:07)
So the overarching theme of this conversation is just mass uncertainty, lots of hypotheticals shooting out in every different direction, and no one really knows what's going to happen when we finally hit that X date, the drop dead date. But there is something sort of more immediate, a potential more immediate impact. And I think we touched on this when we were talking about TGA balances, this idea of, you know, the Treasury’s checking account at the Fed, it does have an impact on liquidity.
So what's going on with the TGA, you know, if there's more money in there, if there's less money in there, it can mean different levels of liquidity for the broader economic system for companies that might be due payments from the government. Talk to us a little bit about the immediate impact of all this discussion over the debt ceiling on market liquidity and monetary policy as well?
George: (38:01)
Yeah, so this is kind of a perverse thing about how the mechanics of the TGA being inflated with that sort of cushion we discussed earlier. It's perverse how this works because when the Treasury is building up that cushion, they are withdrawing aggregate liquidity from the private sector. Treasury is withdrawing liquidity from the private sector because that increase in TGA balances is being funded by some combination of higher debt and, you know, higher taxes relative to spending its debt, right?
The Treasury's issuing more bills and more notes and bonds than they technically need for the specific period in time. That means cash balances are being dragged out of the private sector and to the Treasury's cash balance at the Fed, that's a Federal Reserve liability, just like a Fed Fund is, but the liability that the Fed holds in the TGA, the only asset, the only person who can hold that as an asset is Treasury.
Whereas Fed Funds are an asset that can be held by the banking sector and used to match against deposits that are an asset of the rest of the private sector. So basically it's like reverse QE, right? When this TGA is being built up, it's pulling liquidity out of the private sector and storing it in the TGA, then as the TGA is released, it does the opposite, right? So it unleashes private sector liquidity because that liability of the Federal Reserve to the Treasury is being spent down, the payments are winding up as assets of the rest of the private sector, or the rest of the world, basically everybody but the federal government funded by Federal Reserve/Fed Funds liabilities at the Fed.
So it's basically a countercyclical thing, right? Like as times are good and we're, you know, going along the TGA gets built up and then, oh, we've got worries about debt ceiling, but at the same time a bunch of liquidity is being unleashed.
Now the sizes here are not necessarily huge. It sort of depends on the specific instance, but the size of the TGA has gotten pretty big relative to the rest of the Fed's balance sheet as a matter of course since 2015. So prior to the global financial crisis, 2007 to 2008 kind of range, the TGA was less than 1% of the Fed's balance sheet. Basically payments in/payments out almost precisely matched each other day-to-day. From 2008 to 2015, it built up a little bit because just the scope of federal government spending went up. There was a lot more issuance of debt with post-crisis deficits that slowly sort of declined from the peaks in 2009. But then when we get to 2015 and Treasury says, ‘okay, well we want to start building up this cash balance.’ from 2015 to 2020, it averaged 6% of the Fed's balance sheet.
So it was below 1% before the global financial crisis. Immediately after, it’s about 2%. After that, after 2015, 6%. Since Q1 of 2020, it's been 11% of the Fed’s balance sheet. That's a huge percentage of the Fed’s balance sheet. And it swings around quite a lot unlike, for instance, the QE asset purchase portfolio.
So basically you've got this complicating factor that has nothing to do with the Fed’s monetary policy setting. The Fed is not changing policy based on Treasury cash management, and yet it's got this sort of impact on aggregate private sector liquidity, both positive and negative depending on what's going on with the TGA, that you have to count for. So, you know, as we see the TGA spend down over the next few months, it's already underway, that will have an impact on aggregate private sector liquidity.
That will be kind of, sort of counterintuitive, I guess you could say. Right now there's about $560 billion in the Treasury general account. That's down from a peak of almost a trillion in May of last year. The recent peak, it's sort of trended lower over the past seven months or so, and that'll continue to trend lower as we go from 560 down to zero presumably, or near zero at the X day.
Joe: (41:47)
All right. I want to ask one more markets-related question, and I think there's this fantasy that people have, which is that the stock market becomes this sort of forcing mechanism. The example that everyone would cite is the Tarp vote, it failed in 2008. The stock market crashed some more and then they passed it a couple days later. It doesn't seem like that dynamic really holds with the debt ceiling because even though there's this potential for catastrophe, uncertainty, the view among stock investors seems to be, they always get it done in the end, why would I sell my stock? Etc. Can you talk a little bit about, as we get closer, is there any sort of history or the sort of interplay between market volatility and pressure to just, all right, let's get it passed?
George: (42:33)
There is no doubt that there is a feedback loop between asset markets and how politicians think in this country. I mean, using a more recent example than the Tarp vote, which I think is a good one, you could look to what happened in the spring of 2020, right? We saw a degree of fiscal stimulus and a degree of support for households that is completely unprecedented in American history. And completely, if you had dreamed up the scenario where that happens, even if you had, you know, known about Covid coming and you had said, ‘okay, well then you're going to see this public sector response to that.’ I don't think anyone would've believed you, they would have just said, ‘no, there's no way that the Republican congress will do that. There's no way that Republicans in Congress will, there's no way that I'll get through filibusters and all that.’
And it absolutely did, and it did so immediately because asset markets were in free fall, right? There is a lot more feedback to political economy in this country and to political outcomes in this country from the stock market than from the unemployment rate. That is just how things work. I'm not defending that, it's just the reality.
So I do think that if we see stock markets start to fall, you know, measurably, you know, like big volatility, big downside in the months or weeks leading up to the sort of X date, as it sort of becomes more clear, then you will definitely see a lot of pressure on politicians to just raise the dang thing. You know, have your fights about something else. Whether that comes from people within the respective ideological circles of each party, whether that comes from the public as a whole, it's unclear, but either way, there will be significant pressure.
If however, stock markets say, ‘well, you know, they'll figure it out and even, you know, maybe there'll be a default, but they'll pay those back eventually and people will be compensated,’ and there'll be plenty of people that are willing to pick up an extra 25 basis points in a Treasury bill to hold it for a few months while they figured all this out and it'll be fine, and so we can just sort of look past that. If that happens, that's a recipe for a much more protracted fight and a much longer time past the X date with, you know, uncertainty going on.
Now my view would be that if you get to the X date, even if you have prioritization, barring using one of the technical workarounds we discussed, so either the coin or using high coupon bonds or just saying, ‘Well this violates the 14th amendment, so we're going to ignore the debt ceiling.’ If you don't have those and you have either prioritization, which Treasury said is impossible but could be possible, and you're working through prioritization, or if you're just doing a general default or ‘we're not paying any payments until the debt ceilings raised, because that's what the law tells us to do,’ if I'm the Treasury, okay, either way, in either a severe prioritization scenario or a general default, you are going to have large economic impacts from that, right?
The volume of outgoing payments that are not going to show up in the bank accounts of people that want to spend them, whether those are businesses, whether they're individuals, is going to be really big. Social security is a really good example. If you stop paying social security, the entire economy grinds to halt in about a month. There's just not, it's just such a huge cash flow for such a large percentage of the population that you can't. So eventually there will be a feedback to asset markets. This will not last forever where it's just kind of the new normal that the US is permanently, you know, has the debt ceiling in place and is only making some outgoing payments.
Eventually the economy starts to collapse, the stock market starts to collapse. And another interesting thing just to work it back to the Fed, an interesting thing to think about is if the economy is collapsing because all these payments aren't going out and the stock market is in free fall, does the Fed step in to say, ‘okay, well we're going to cut rates now because the economy's in free fall because of what's going on with the debt ceiling,’ or do they say ‘not our problem’? I don't know, I don't have a good answer for that. I don't think a good answer exists, but it's something interesting to think about.
Tracy: (46:14)
It feels like this is one of those topics where there just aren't a lot of good answers.
Joe: (46:18)
But George did a good job.
Tracy: (46:19)
Yeah, you did a great job. That was great. There's a lot of uncertainty and hypotheticals as we've been talking about. It's not an easy thing to sort of lay out all the different options and what might happen depending on what's pursued. But George, it was great having you on. You did a great job. Thank you so much.
George: (46:34)
Yeah. Thanks for having me on. I mean I can stick around for another three hours and we can really get all the different hypotheticals if you want.
Joe: (46:40)
All right, now hour two, the coin conversation.
Tracy: (46:43)
Okay, I'm leaving.
George: (46:44)
Bam. Let's go. Thanks for having me on.
Joe: (46:47)
Take care George.
Tracy: (46:47)
Thanks George. Joe, there's a lot to unpack from that conversation.
Joe: (47:04)
I agree, but George did like a great job. So, you know, there is a lot of uncertainty. I guess, because it's something that had been lodged in my mind, but I'm glad he brought up that question of the software element of settling defaulted debt because it's just something, we don't talk about debt in those terms.
Tracy: (47:23)
It seems totally like a Y2K type thing as you mentioned, where people just would not expect US Treasuries to default and anyway, why would you prepare for such a scenario? Because if that were to happen then it would be the collapse of the financial system as we know it. But yet, here we are, you know, after 2011, after 2013 having a very similar conversation.
The other thing that stuck out in my mind was George's point about, you know, ultimately this is a political proces.. And it plays out in debt, but the reason it plays out in the debt market is because debt is inherently, I think, so tied up with questions of morality and justice and it's so easy to build a political narrative on top of something that is ultimately about who owes what to who and why.
Joe: (48:15)
Absolutely. And, you know, I think that's why it's really notable that this was written into the constitution. And it was written into the constitution after the Civil War. And when we did have that coin conversation, it was with Rohan Grey in 2021, he talked about this as well, which is that this fear that in the pursuit of the Civil War, that representatives from the formerly Confederate states would try to induce a default because it's like, ‘oh, we don't want to pay the debts of the northern government that fought a war against us.’ And so it gets to deep constitutional questions and it continues to play out over and over again in different forms.
Tracy: (48:54)
The political weaponization of debt. And it seems to be happening more often, because I think people have realized that it is an effective pressure point as George laid out. Well, on that happy note, shall we leave it there?
Joe: (49:07)
Let’s leave it there.
You can follow George Pearkes on Twitter at @pearkes.