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The Debt Limit

July 29, 2011

To get the preliminaries out of the way: A default would be a very bad thing. The Republicans are being stupid, but so is Obama for refusing to sign a temporary measure. If you want a smaller government, the best way to do it is to reduce spending by eliminating ineffective government programs. Going back and refusing to pay your bills just raises interest rates and causes a higher cost of financing the debt resulting in higher taxes in the long run.

Nothing I can tell you about the politics will be more interesting than what others have already said on this issue, but I want to run over a few scenarios where default can be avoided.

Order the Fed to destroy bonds
The whole idea of the Fed “owning bonds” is a gimick anyway.

Unconstitutionality
“The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”
The debt authorized by law shall not be questioned. So legal debt shall not be questioned, but does Congress authorize debt when it sets a tax rate and spending rate (the deficit is endogenous to those two variables), or does it authorize debt when the debt ceiling is raised? If Obama tells the Treasury to pay anyway, Republicans in Congress could take him to court, but it would buy some time.

Coin Seigniorage
The long run effects might include a bit more inflation than otherwise, but honestly we could use inflation right now, so I see pretty much no short run downside to this option right now.

Overdraw Fed account
You can, why not the Treasury? Do you really think Bernanke is going to bounce Obama’s checks?

It’s stupid to even be talking about this when 30 year treasuries are under 5%. Clearly the market doesn’t think our debt is either risky or unsustainable.

2 Comments leave one →
  1. July 29, 2011 3:18 pm

    Re: “the market doesn’t think our debt is either risky or unsustainable”

    What do you think of Nate Silver’s analysis of the market that he made here: http://fivethirtyeight.blogs.nytimes.com/2011/07/25/washington-is-out-of-touch-how-about-wall-street/ ?

    • July 29, 2011 4:09 pm

      I think his model of how default risk will change is unrealistically pessimistic. The price of a bond does not change based on the daily risk of default, it depends on the risk that a bond will default before it is paid. So the return on a 5 year bond prices in the expected risk of default any time within the 5 years. If you want to see what bond returns look like on countries that have a high risk of default, look at Greece or Portugal.

      That’s why I picked the 30 year bond. The markets simply don’t expect the U.S. to default. Not now, not any time in the next 30 years. I don’t know if that means they are out of touch. Maybe they are. In that case, short Treasury bonds.

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