US Economy
Dr Peter Morici: The debt ceiling and funding the US government after August 2; Running QE2 in reverse
By Professor Peter Morici
Jul 18, 2011 - 6:14 AM

President Barack Obama, Ruby Bridges, and representatives of the Norman Rockwell Museum view Rockwell’s "The Problem We All Live With,” hanging in a West Wing hallway near the Oval Office, July 15, 2011. Bridges is the girl portrayed in the painting. The event was in commemoration of the 50th anniversary of Ruby Bridges’ history-changing walk to the segregated William Frantz Public School in New Orleans that later inspired the American painter to create the piece for the January 14, 1964 issue of Look magazine. Bridges has said that she thought that the jeering white parents at the school, were part of the Mardi Gras festival.

Dr Peter Morici: If the US debt ceiling talks fail, is August 2 really the drop dead date for a US default?

Perhaps!

The President has said that the Congress needs a deal by July 22 to get legislation through Congress by August 2. I don’t buy it.

As long as a deal is struck by August 2, something can be patched together. However, the President and Treasury secretary have so convinced most everyone that Treasury will be out of money by August 2, that a week before, interest rates investors demand on Treasurys may rise precipitously and the bond market routs. At that point, there may be no turning back.

It is unfortunate the President and Treasury secretary are spreading around calamity scenarios, because the Treasury really does have options after August 2 if they don’t scare the markets into panic before then.

The Treasury will still be receiving 55% of its tax revenues and can easily pay the interest on the debt, and should then be able to roll over bonds coming due. For the balance of Federal expenses, the Treasury will have to prioritize, but it will have enough money for Social Security, Medicare and Medicare. Some checks may have to be spread out to accommodate discrepancies between payment dates and cash flows, but interest payments are modest enough, relative to the total cash coming in, that those can be met on time.

Selective payment of federal bills is possible - - it was planned for government shutdowns when the Congress and President failed to approve appropriations - - and it can be accomplished again if planned prior to August 2.

If no other sources of funds are found, the bond rating agencies have indicated failure to pay vendors and contractors on time would result in a downgrade in US government’s AAA rating; that is likely to happen but a downgrade is not a default. As long as interest is paid on the bonds, the United States has not defaulted on the national debt.

A downgrade is likely no matter what comes out of current negotiations. Specifically, Standard and Poor has indicated a $4trn deficit reduction package is necessary by August 2 to avoid a downgrade. That simply is not possible given the President’s aversion to genuine spending cuts - - evidenced by his failure to table concrete spending cut proposals—and the insistence on no new taxes by many members of the Republican House caucus.

Also, S&P is assuming a 3% GDP growth rate in projections of the future revenue, spending and debt to GDP ratios. Three percent growth is not likely to be attained this year or next without pro-growth reforms the President is ideologically opposed to accepting. This will all come to a head in February when the Administration publishes its FY2013 Budget proposal and 10 year deficit projections.

Funding could be found for the remaining 45% of expenses. Consider the minuet the Treasury and Fed were dancing through June 30 under QE2 (a cruise liner to some but in the period of the financial crisis, the second program of quantitative easing by the Federal Reserve, where the central bank purchases long-term US Treasury bonds in the market, thereby pushing down yields - - interest paid as a ratio of the current market value of a security - - and other interest rates across the debt markets that are closely tied to US Treasury rates, including 30-year mortgage rates. Quantitative easing is commonly termed 'money printing' as the impact is the same as increasing the money/credit supply in the economy).

The Treasury printed and sold bonds to the public, and the Fed printed money to buy up most of those bonds. Simply, the Fed monetarized most of the new debt from November to June. The Fed currently holds $1.6trn in Treasurys and over $2.6trn in Treasurys, federal agency bonds, and mortgage-backed securities.

Roundabout, under QE2, the Treasury and Fed were printing money to pay more than a third of the government’s bills.

On August 2, the Treasury may not be able to print and sell bonds, but it too can print money to pay its bills. That would flood markets with cash, but the Fed can mop up the excess liquidity by selling off the bonds it has accumulated these past seven months. (It is important to note, the bonds the Fed holds already count against the debt ceiling, and selling those to the public does not pierce the ceiling for the purposes of the statutory debt limit.)

Whereas through June, the Treasury printed and sold the bonds and the Fed printed the money and purchased most of those bonds back, now the Treasury can print money to pay its bills, and the Fed can sell the bonds to mop up most of the new money.

Irresponsible? No more so than QE2, and much less so than letting the US default on its debt or leaving grandma without groceries.

The Fed balance sheet could carry us through the next election, no problem.

President Obama on Debt Talks:

President Obama Presser Q&A: