Tuesday, January 31, 2023

The Fed and the Debt Limit

What's the matter with a temporary delay in paying interest and principal on debt, if the debt limit hits? Collateral. Financial institutions can easily borrow using treasury securities as collateral.  If a treasury is in technical default, it suddenly can't be used as collateral, or you can borrow much less money with it. Thus even a technical and temporary default, even if we all know Uncle Sam will eventually repay the debt, is dangerous to the financial system. (Why we have so much short term collateralized borrowing is a topic for another day. We do, and unwinding it suddenly would be bad.) 

Earlier I argued that the Treasury should stand up and say "we will pay interest and principal on Treasury debt before we pay anything else." It's important to say that now to avoid a run. I suspect they will do it in the end, but want to use the threat of a crisis to get Congress to raise the limit promptly. If so, they're playing with fire, as runs start ahead of time. 

Today, however, I've been thinking about what the Fed can do. First, the Fed can say right now, in the event of a debt ceiling technical default, we will suspend all our rules and allow financial institutions to lend against treasury collateral with customary (tiny) haircuts, ignoring the technical default. Second, the Fed can say it will lend freely against treasury collateral to banks, or via reverse repos to financial institutions, with no haircut, even if the securities are in default. Third, the Fed can say it will buy Treasurys. It will fix a low rate of interest and buy all anyone wants to sell at that price. Will private markets make some money off this? Yes. Fine. That's the point. Hang on to your treasurys, you'll make some money is a lot better than starting a crisis. If the Fed overpays, it just remits less to Treasury eventually. 

Say it now, so there is no run as the debt ceiling approaches. 

The one thing Fed and Treasury will clearly not be able to do under a debt limit is to run another big bailout. So make darn sure we don't need one! 

What about the trillion dollar coin? Clever, but as before, issuing interest-only debt is even more clever. The debt limit only counts principal, not market value, so interest only debt doesn't count! But both that and the trillion dollar coin are so obviously against the spirit of the debt limit, that if Treasury is worried about its authority to prioritize treasury debt over (say) electric car subsidies, then either is not worth discussing. 

Updates:

Chris Russo wrote in Barrons Sept 2021 reporting on internal Fed strategizing for this event. 

The Fed will treat defaulted Treasury obligations the same as non defaulted obligations. Their regulatory treatment will remain the same including capital requirements and risk weights. Moreover these securities "will not be adversely classified or criticized by examiners." 

Policy makers would "presumably want to avoid the impression that the Federal Reserve was effectively financing government spending." 

The Fed will 

transact with defaulted securities at market prices

Eventually 

The Fed could move the defaulted securities on to its balance sheet [English translation: buy] ...this set of options is the most contentious. Powell described them as "loathsome"... the institutional risk would be huge. The economics of it are right but you'd be stepping in to his difficult political world and looking like you are making the problem go away. Lacker called it "beyond the pale." John Williams... supported keeping those options on the table. ...no Fed governor categorically rejected the third option. 

As I read it, this is considerably less than what I described. The Fed worries here about not inadvertently forcing individual banks to treat treasury assets as defaulted securities, which is good. But the main issue is whether financial markets, many not banks, will accept treasury collateral for lending, or whether we have as in 2008 a grand unwinding of the chain of short-term financing due to lack of collateral. Only the "loathsome" option addresses that issue as far as I can see. And if you want to stem a collateral run, it's best to clarify ahead of time. 

Casey Mulligan inquired

I am confused about your proposal.  Fed is part of the government. With currency in circulation not (?) counting against the debt limit aren't you suggesting the Treasury debt be (contingently) replaced with currency? Or would the Fed be defaulting on whatever asset it lends out?

Boy, if I didn't explain it well enough for Casey, I must really need a remedial writing course. Answer/clarification: 

Sorry if not clear. Fed can buy / lend against existing treasury debt, in default, and offer cash/reserves in exchange. This solves the financial crisis issue. It does not allow the treasury to borrow more, or the Fed to finance deficits. 


29 comments:

  1. If the Treasury is “playing with fire” by /not/ suspending normal rules, what is the role of the GOP-controlled House in this fire? I appreciate the effort in this post to find a way to recover the hostage, but let’s be clear on who the hostage-taker is.

    ReplyDelete
    Replies
    1. Not really a hostage taking scenario. More of a staring contest - who will blink first?

      Delete
  2. "What about the trillion dollar coin? Clever, but as before, issuing interest-only debt is even more clever."

    Coin issuance has already been approved by Congress. Interest only debt would require Congressional approval.

    And the coin isn't as clever as you think it is. Democrats "threaten" to mint the coin. Republicans counter with payment prioritization, any proceeds from sale of coin will be used to retire existing debt. Debt ceiling is reduced by Republicans. Rinse and repeat.

    Both get what they want - Republicans get reduction in debt, Democrats get a shiny coin.

    Or this:
    https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

    Republicans get lower taxes AND lower debt
    Democrats get spending in excess of revenues

    ReplyDelete
  3. Democrats are only interested in Debt they can Steal.

    ReplyDelete
  4. I have mixed feelings about the Fed getting preemptively involved. True, we need to make sure we don’t need another big bailout. But signaling that the Fed stands ready to bail out yet another major bout of recklessness, this time by Congress? I almost wish for the opposite strategy, that the Fed could credibly commit to not intervene, explain clearly what the consequences of a technical default would be, and tell Congress, “do as you please.” Not realistic, I know, but still…

    ReplyDelete
    Replies
    1. There is this thing called risk absorbing equity (something that Geithner, Bernanke, and Paulson seemed to forget about).

      This:
      https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

      No Fed involvement required.

      Delete
  5. Another advantage of the interest only debt (at least in the form of fixed rate perpetuities) is that you eliminate interest rate risk associated with the need to roll over treasury debt as it comes due. (I believe you have made this point previously!)

    The reason not to do that is it may signal a lack of commitment to spending control, but I'm not sure there is really much of a signal now...

    ReplyDelete
    Replies
    1. This has been tried in Europe when the sovereign defaulted on his fixed term debts. Perpetuities were issued in exchange for the defaulted securities on the same premise that you cite in advocating for this course of action. All such legerdemain strategies ultimately fail for the same reason: Unsound fiscal management.

      If patriotism is the last refuge of a scoundrel, then perpetuities are a second-best refuge for the spend-thrift debtor.

      Delete
  6. Interesting to see what the arguments will be regarding the negotiations over debt limit based on Powell 25bp target increase in FFR and commenting of inflation receding. How much due to the Fed vs markets adjusting from Covid causing disequilibrium between supply and demand

    ReplyDelete
  7. The "Run" problem is real. What's terrible about runs is that funds are distributed in first-come-first-serve basis rather than pro-rata, like equity.

    I would propose that, at least, the Treasury should make a law/policy that if they can't pay all of their required payments, they will all be impacted pro-rata. That includes entitlements like social security, medicare, and interest payments.

    What we will see when such a policy is made, is that suddenly people voting for entitlements will care a lot more about government solvency, because the chance of not receiveing full reimbursement would be severe.

    At the same time, people don't need to worry that suddenty the government won't make ANY payments on either interest or social security, and the won't gain anything by running to cash out fast either.

    This would completely avoid the possibility of a "run" on government funds.

    ReplyDelete
    Replies
    1. "The Run problem is real. What's terrible about runs is that funds are distributed in first-come-first-serve basis rather than pro-rata, like equity."

      Okay, so have government switch from debt financing to equity financing.

      This:
      https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

      "I would propose that, at least, the Treasury should make a law/policy that if they can't pay all of their required payments, they will all be impacted pro-rata. That includes entitlements like social security, medicare, and interest payments."

      No need to make a new law / policy. Equity financing is already legally recognized and is available to the US Treasury under Article II, Section III of the US Constitution.

      Delete
    2. Fish,

      A program like Social Security has some advantages (and disadvantages) that your average run of the mill government bonds do not.

      Advantages:

      1. With a few exceptions, the government's liability to the beneficiary dies when the beneficiary dies. Contrast that with government bonds that are an inheritable asset or can be sold in the open market to a younger individual.

      2. Enrollment and returns on investment for Social Security are contingent on the beneficiary working and paying taxes up until retirement age. No such effort is required to receive interest payments on government bonds.

      3. Regarding "runs", it is impossible for anyone to try to obtain ALL of their accrued Social Security benefits at once. It is possible for all bond holders to try to sell all of their bonds into the market at once.

      Disadvantages:
      1. Enrollment in the Social Security system is mandated upon individuals by the Federal Government.

      2. Returns on investment in the Social Security system are not available until after retirement.

      So take the advantages of Social Security, eliminate the disadvantages and you end up with something like this:

      https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

      Delete
  8. so deficit and debt are only of interest when a democrat is president and the debt servicing ratio is falling?
    you yanks have very strange habits that make no sense at all

    ReplyDelete
  9. Stop making sense, Dr. Cochrane. Ha.

    Maybe you should be running the Fed. :D And the Treasury.

    ReplyDelete
  10. Don't forget Social Security.
    14th Amendment includes "pensions" not just debt.
    So Principal, Interest and Social Security.
    I promise if SS checks are delayed it will be unsettling.

    ReplyDelete
  11. A satirical red herring was circulated once for the LBO of IBM.
    The capitalization included perpetual zero coupon notes.
    Chuckles ensued.

    ReplyDelete
  12. "... issuing interest-only debt is even more clever. The debt limit only counts principal, not market value, so interest only debt doesn't count!" -- JHC.

    Nice try! Won't wash. Have you ever wondered why only the principal is used to determine the U.S. debt? Could it be because the discount rate on the stream of coupons and future payment of principal equals the coupon rate of the debt issued? If so, then the concept that the coupon payments on a perpetuity issued by the U.S. Treasury don't count towards the accounting value of U.S. debt issued as perpetuities.

    But there is a contradiction, which can be seen in the following list:

    Term debt: PV = FV ---> implies that the discount rate = coupon rate.

    Perpetual debt: PV = 0 ---> implies that the discount rate = infinity.

    Yet, the perpetual debt is issued for a lump sum, say $1, by the Treasury at auction, resulting in a measurable yield rate, say r%/yr. The perpetuity pays a coupon payment (semi-annual) is c$/yr. Ergo, PV = c$/yr ÷ r%/yr = c$/r% × 100%/% = $1. This resolves the contradiction.

    Bottom-line: "There's no free lunch." Perpetuities will add to the U.S. government debt and counted towards the debt limit threshold.


    ReplyDelete
    Replies
    1. John seems to think otherwise with inflation indexed bonds.

      Delete
    2. Wall Street believes in free lunches - see bailouts.

      Delete
    3. Larry Summers believes in free lunches - he was part of the Treasury department under Rubin (eventually becoming Treasury Secretary) when TIPs and I-Bonds were introduced.

      He was Director of National Economic Council under the Obama Administration when the bank bailouts were initiated.

      Delete
  13. The Fed I suppose (sort of) does this already vis a vis the standing repo facility. The more elegant solution would be to purchase any maturing bonds or stripped coupons at par.

    This all sounds easy in writing but in reality the operation complexities with doing something like this would be massive.

    ReplyDelete
  14. Haven't seen one reason not to issue the $100 Trillion Platinum Coin. Other than "it feels funny". Total nonsense. Biden should issue it now, and let the Rebugs move on to grooming scares.

    ReplyDelete
    Replies
    1. Haven't seen one reason why $1 Trillion is the right number or $100 Trillion, or $1 Quintillion.

      Delete
    2. A smart Democrat would realize that Treasury can sell tax breaks instead of bonds thereby lowering taxes AND reducing the federal debt leaving the "Rebugs" nothing to run on in the next or any other election.

      Want to see Democratic control of Congress for any extended period of time (for instance 1959-1981)? Do that.

      "War is a moral contest, and they're won in the temples before they're ever fought." - Sun Tzu.

      Delete
    3. Selling tax breaks is a tax cut which requires Congressional approval. $100 Trillion coin does not. Trillion, $100 Trillion, makes no difference other than how long you want to eliminate debt ceiling problem for.

      Delete
    4. The question you need to ask yourself is should Biden / Yellen successfully sell tax breaks, why would any person in their right mind vote Republican ever again? For a never ending string of wars - um, no thanks.

      Delete
    5. Selling tax breaks is a financing option in the face of government deficits. One way to finance deficits is to sell bonds. Another is to sell tax breaks.

      Delete
    6. "Trillion, $100 Trillion, makes no difference how long you want to eliminate debt ceiling problem for."

      You see the debt ceiling issue as a "problem". I see it as an opportunity for Democrats to create a lasting governing majority.

      Which would you feel better about?

      A $100 Trillion coin and Democrats losing a majority of elections going forward (lasting Repugs majority in Congress)?

      Tax breaks sold by Treasury and Democrats winning a majority of elections going forward (lasting Repubs minority in Congress)?

      "War is a moral contest, and they're won in the temples before they're ever fought." - Sun Tzu.

      Want to be on the winning side or the losing side of this "moral contest"?

      Delete
  15. A program like Social Security has some advantages (and disadvantages) that your average run of the mill government bonds do not.

    Advantages:

    1. With a few exceptions, the government's liability to the beneficiary dies when the beneficiary dies. Contrast that with government bonds that are an inheritable asset or can be sold in the open market to a younger individual.

    2. Enrollment and returns on investment for Social Security are contingent on the beneficiary working and paying taxes up until retirement age. No such effort is required to receive interest payments on government bonds.

    3. Regarding "runs", it is impossible for anyone to try to obtain ALL of their accrued Social Security benefits at once. It is possible for all bond holders to try to sell all of their bonds into the market at once.

    Disadvantages:
    1. Enrollment in the Social Security system is mandated upon individuals by the Federal Government.

    2. Returns on investment in the Social Security system are not available until after retirement.

    So take the advantages of Social Security, eliminate the disadvantages and apply the result to the rest of government finance.

    This:
    https://musingsandrumblings.blogspot.com/2019/09/the-case-for-equity-sold-by-u.html

    The "progressive" arm of the Democratic Party (if there ever was such a thing) left the party long ago and that departure was spearheaded in part by Larry Summers.

    "Free Lunch" Larry Summers was part of the Treasury department under Rubin (eventually becoming Treasury Secretary) when TIPs and I-Bonds were introduced.

    "Free Lunch" Larry Summers was Director of National Economic Council under the Obama Administration when the bank bailouts were initiated.

    And nothing you have said has convinced me that has changed - the "Free Lunch" crowd has totally enveloped the Democratic Party.

    ReplyDelete

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