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A Project of The Annenberg Public Policy Center

Defining Default

President Obama says failing to raise the debt limit on Oct. 17 will “force the United States to default on its obligations.” Sen. Rand Paul contends “there’s no reason for us to default,” because the government collects enough revenue to meet its interest payments on the debt.

Who’s right? It depends on the definition of “default,” but many economists — including those at nonpartisan and bipartisan groups with ties to former economic advisers of Republican leaders — warn Paul’s narrow definition underplays how the marketplace would react to any default of payments, whether to bondholders or others.

With Congress locked in a stalemate on the debt ceiling, Treasury Secretary Jack Lew warned Congress that there will be insufficient cash on hand to meet all of the country’s obligations, unless Congress raises the $16.7 trillion debt limit by Oct. 17. This year the government is borrowing nearly 19 cents of every dollar it spends, according to the most recent projection by the nonpartisan Congressional Budget Office (see Table 1).

So, without debt ceiling relief, new federal obligations will exceed incoming revenue.

As the Oct. 17 deadline looms, Obama has repeatedly warned of a pending “default” if the debt ceiling is not raised, and the dire consequences such a default would have on the American economy.

“This time, [Republicans] are threatening to actually force the United States to default on its obligations for the very first time in history,” Obama said on Oct. 3. “In an economic shutdown, falling pensions and home values and rising interest rates on things like mortgages and student loans — all those things risk putting us back into a bad recession.”

Paul contends Obama’s warnings about a default are nothing more than an attempt to “scare the marketplace.” Paul laid out his reasoning in an interview on NBC’s “Meet the Press.”

Paul, Oct. 6: I think it’s irresponsible of the president and his men to even talk about default. There’s no reason for us to default. We bring in $250 billion in taxes every month. Our interest payment is $20 billion. Tell me why we would ever default. We have legislation called the Full Faith and Credit Act, and it tells the president, “You must pay the interest on the debt.”

So this is a game. This is kind of like closing the World War II Memorial. They all get out on TV and they say, “Oh, we’re going to default.” They’re the ones scaring the marketplace. We shouldn’t scare the marketplace. We should never default. There’s no reason to default.

Paul’s claim — echoed by other Republicans – is based on his conviction that the U.S. could prioritize its debt payments, essentially choosing to pay interest on outstanding debt first. That’s a matter of some debate.

Treasury officials say they do not have the legal authority to prioritize payments, that all obligations stand on equal footing. The Full Faith and Credit Act referred to by Paul would require that Treasury repay obligations of debt held by the public and to the Social Security Trust Funds first. The bill passed the House, but sits in committee in the Senate.

On Jan. 21, 2011, Neal Wolin, deputy secretary of Treasury, called prioritization “unworkable.”

“It would not actually prevent default, since it would seek to protect only principal and interest payments, and not other legal obligations of the U.S., from non-payment,” Wolin said. “Adopting a policy that payments to investors should take precedence over other U.S. legal obligations would merely be default by another name, since the world would recognize it as a failure by the U.S. to stand behind its commitments.”

And in a letter to Sen. Orrin Hatch on Aug. 24, 2012, the Treasury inspector general wrote: “Treasury officials determined that there is no fair or sensible way to pick and choose among the many bills that come due every day. Furthermore, because Congress has never provided guidance to the contrary, Treasury’s systems are designed to make each payment in the order it comes due.”

But again, this is a matter of debate.

A Congressional Research Service report last month noted that in 1985 the nonpartisan General Accounting Office (now known as the Government Accountability Office) weighed the issue of whether bills would have to be paid on a first-in, first-out basis and concluded that “the Secretary of the Treasury does have the authority to choose the order in which to pay obligations of the United States.”

“Treasury is free to liquidate obligations in any order it finds will best serve the interests of the United States,” the GAO wrote at the time.

Moody’s Investors Service, in an Oct. 7 report, also said that it expects Treasury to prioritize its payments. “In our view, the government is very likely to prioritize interest payments because of the potentially serious effects a default would have on financial markets in the US and globally,” Moody’s said.

Market Response

But even if Treasury could prioritize payments, economists say that wouldn’t likely satisfy the financial markets.

“That’s still a problem,” Satya Thallam, director of financial services policy at the American Action Forum wrote to us in an email. The American Action Forum is a self-described “center-right” organization that is led by Douglas Holtz-Eakin — a former director of the Congressional Budget Office who served as Sen. John McCain’s chief economic adviser during the 2008 presidential campaign.

“For investors, and all the parties who depend on the safety and liquidity of U.S. debt, they might not particularly care about which payments are made (notwithstanding debt service payments),” Thallam said. “But the necessity to do so will spook markets.”

Thallam went on to discuss “a concept in personal finance called ‘universal default,’ ” which is the ripple effect of paying one creditor but not another.

“When I fail to make a utilities payment, a credit card company shouldn’t particularly care as long as I keep paying my credit card balance. However, my inability to make ongoing payments for any of my due liabilities should worry them and goes to my creditworthiness and ability to repay (generally speaking),” Thallam said. “As a result, under the concept of universal default, a credit card company who receives that information (about missed payments elsewhere in my credit portfolio) might like to raise my interest rate or lower my credit limit accordingly to the new revealed risk. While much of that practice has been prohibited in the U.S. under consumer protection law, there’s no such prohibition on sovereign debt.”

Lawrence J. White, an economist at New York University’s Leonard N. Stern School of Business, echoed that warning in an email to us, saying that missed payments on any government obligations could degrade the “creditworthiness of the U.S. Government.”

“Even if the federal government were to make choices as to who to pay — say, pay all of its debt obligations promptly but not pay other obligations promptly — the creditworthiness of the U.S. Government might still be called into question,” said White, who served on the senior staff of the president’s Council of Economic Advisers during 1978-1979 in the Carter administration. “Holders of bonds might start to wonder, ‘Well, they paid me promptly this time, but they didn’t pay some of their other obligations promptly. Maybe next time I’ll be the guy who they decide should receive the delayed payments?’ Though this might not have the sharp effects of not making payments on the debt, it could still erode the perceived creditworthiness of U.S. debt instruments, raise interest costs, etc.”

Here’s how a Sept. 19 report from the Congressional Research Service — titled “Reaching the Debt Limit: Background and Potential Effects on Government Operations” — explained it.

CRS, Sept. 19: If the debt limit were reached and interest payments on debt were paid, it is not clear what the repercussions would be on the financial markets or the economy. If Treasury had to rely on incoming cash to pay its obligations, a significant portion of government spending would go unpaid. Removing a portion of government spending from the economy would leave behind significant economic effects and would have an effect on GDP by definition, all other things being equal.

Further, if the government fails to make timely payments to individuals, service providers, and other organizations, these persons and entities would also be affected. Even if the government continued paying interest, it is not clear whether creditors would retain or lose faith in the government’s willingness to pay its obligations. If creditors lost this confidence, the federal government’s interest costs would likely increase substantially and there would likely be broader disruptions to financial markets.

The Oct. 7 Moody’s report, however, contradicted the dire warnings about the consequences for U.S. creditworthiness.

Moody’s, Oct. 7: We believe the government would continue to pay interest and principal on its debt even in the event that the debt limit is not raised, leaving its creditworthiness intact. The debt limit restricts government expenditures to the amount of its incoming revenues; it does not prohibit the government from servicing its debt. There is no direct connection between the debt limit (actually the exhaustion of the Treasury’s extraordinary measures to raise funds) and a default.

In fact, Moody’s wrote, the situation is better now than it was when the country faced a debt ceiling impasse in 2011. “The budget deficit was considerably larger in 2011 than it is currently, so the magnitude of the necessary spending cuts needed after 17 October is lower now than it was then,” the report states.

Standard & Poor’s Ratings Services, meanwhile, said the current dispute over the debt ceiling and federal budget could affect the U.S. economy — in particular “confidence, investment, and hiring in the U.S.” — but not necessarily its credit rating, so long as the impasse is short-lived. One reason is because the agency already had downgraded the U.S. rating because of “political brinkmanship.”

Standard & Poor’s, Sept. 30: In our opinion, the current impasse over the continuing resolution and the debt ceiling creates an atmosphere of uncertainty that could affect confidence, investment, and hiring in the U.S. However, as long as it is short-lived, we do not anticipate the impasse to lead to a change in the sovereign rating. This sort of political brinkmanship is the dominant reason the rating is no longer “AAA.”

That report went on to say that failure to raise the debt ceiling may, however, affect ratings of others dependent on federal funding.

Standard & Poor’s, Sept. 30: We may lower our ratings on obligations that depend on payments by the U.S. government. Other ratings could be affected, depending upon the severity of the impact on financial markets, the payment and settlement systems, and the real economy, in the U.S. and possibly globally. It is difficult to ascertain the impact at this time, given the unprecedented nature of this event.

And that gets us back to the issue of defining default. The CRS report we referenced earlier also addressed the question of “what constitutes a legal ‘default’ by the government.”

CRS, Sept. 19:  No general statutory definition of the term “default” exists; however, Black’s Law Dictionary defines the term “default” as “the failure to make a payment when due,” which, if accepted as the governing definition, would not appear to distinguish between various types of government obligations. Aside from technical definitions, financial markets’ perceptions of what constitutes a default, or a real threat of default, may be more relevant when assessing the potential impacts of not raising the debt limit. For example, if the federal government were to prioritize payments on debt obligations above other obligations, it is not clear whether financial markets would find this distinction to be significant when deciding whether and how to invest in federal government Treasury securities, since Treasury would be postponing payments on other legal obligations. Because perceptions such as these are difficult if not impossible to predict, it is not clear what the effects of prioritization would be, in the event of an impasse.

Thallam added that “the notion of default is a bit in the eye of the debtholder.”

“Sen. Paul may be right that as long as the U.S. does not miss a coupon payment [an interest payment on a bond], it will not be a default,” Thallam said. “And the term of art ‘technical default’ refers to violation of any other loan terms. But the market for U.S. debt (as with all debt) is very forward looking, and any indication that Treasury may have difficulty making future payments (even on Treasuries that haven’t been sold yet) means the status of Treasuries as risk free (and for the time being relatively low-yield) is put in doubt. The change from the current equilibrium to one where yields soar and interest rates rise can happen quickly and non-incrementally.”

In fact, even threatening to breach the limit can cause a negative market response. That’s what happened in 2011.

In a July 2012 report, the Government Accountability Office warned that “delays in raising the debt limit can create uncertainty in the Treasury market and lead to higher Treasury borrowing costs.” GAO estimated, for example, that delays in raising the debt limit in 2011 resulted in an increase in borrowing costs of about $1.3 billion in fiscal year 2011. And those increased costs continue to accrue into the future. The Bipartisan Policy Center said the 10-year cost to taxpayers was $18.9 billion.

“Even though you are picking and choosing who to pay, you’re defaulting toward someone,” Josh Gordon of the Concord Coalition — a nonpartisan organization founded by former Nixon economic adviser Peter G. “Pete” Petersen — told us by phone. “It might not be a bond market default, but you are still becoming a deadbeat on your bills. You are breaking the faith in the government to pay its bills. As far as the market is concerned, it’s the same as defaulting on bond interest.”

Update, Oct. 15:  Fitch Ratings announced on Oct. 15 that it was putting the Unites States’ AAA credit rating under review for a possible downgrade. The announcement warned that, “Although Fitch continues to believe that the debt ceiling will be raised soon, the political brinkmanship and reduced financing flexibility could increase the risk of a U.S. default.”

Unlike the assumption made by Moody’s that Treasury would prioritize payments to bond interest, Fitch wrote, “The Treasury may be unable to prioritise debt service, and it is unclear whether it even has the legal authority to do so.”

According to the announcement, “The U.S. risks being forced to incur widespread delays of payments to suppliers and employees, as well as social security payments to citizens – all of which would damage the perception of U.S. sovereign creditworthiness and the economy … The prolonged negotiations over raising the debt ceiling (following the episode in August 2011) risks undermining confidence in the role of the U.S. dollar as the preeminent global reserve currency, by casting doubt over the full faith and credit of the U.S. This ‘faith’ is a key reason why the U.S. ‘AAA’ rating can tolerate a substantially higher level of public debt than other ‘AAA’ sovereigns.”

Fitch is one of the three main raters along with Moody’s Investors Service and Standard & Poor’s Rating.

— Robert Farley