As it became clear last week that Congress is going to need to raise the Treasury Department’s borrowing limit before lawmakers leave town for the August recess, it simultaneously became less clear what the Trump administration’s position is on what a debt ceiling bill ought to look like.
Treasury Secretary Steven Mnuchin renewed his call for a “clean” debt limit increase -- meaning one that added no contentious riders meant to exploit the must-pass legislation for political gain.
White House Office of Management and Budget Director Mick Mulvaney, on the other hand, said he thought it was perfectly appropriate for Congress to demand spending cuts in exchange for lifting the borrowing limit -- even if the limit merely allows the administration to pay the bills Congress itself has already incurred.
White House senior economic adviser Gary Cohn landed somewhere in the middle, signaling openness to negotiation, as long as the debt ceiling is raised on time.
Mulvaney, however, tried to make at least one thing clear. The Treasury Department, he promised, would not default on its outstanding debt obligations -- Treasury bills, notes, and bonds that trade on the open market.
But a close reading of what the OMB director said is likely to worry US creditors almost as much as a failure to make payments on maturing 30-year bonds.
In a live Facebook chat with The New York Times on Friday, Mulvaney said, “You cannot meet all of your obligations as a nation; that’s not a desirable outcome.” However, he added, there is “absolutely no way” the U.S. would default on Treasury securities.
“We are not going to do that. You can take that off the table,” Mulvaney vowed.
What’s likely to trouble the financial markets in that statement is the distinction Mulvaney makes between payment to debtors who hold Treasury securities and all other payments -- from Social Security checks to the federal payroll to bills from government contractors.
What Mulvaney was signaling is that the Trump administration is returning to an idea that Republicans in Congress put forward in 2011, during a debt ceiling crisis that brought the country to the brink of default. The idea is payment prioritization -- the idea that as it started to run into serious cash flow problems, the Treasury would simply pay some creditors but not others.
Creditors holding Treasury debt would get priority, to preserve the United States’ unblemished reputation as a reliable borrower and to try to maintain the status of US government debt as the gold standard of “risk-free” assets. Other creditors who aren’t as “important” would be made whole at a later date.
The idea is that by keeping existing bondholders happy, there would be no disruption in the market, and therefore, in theory, at least, Treasury debt would retain its privileged place in investors’ portfolios and the low borrowing costs that come with it.
But there is a fundamental problem with this strategy that former Treasury Secretary Jack Lew highlighted during another debt limit standoff in 2013.
“Prioritization is just a default by another name,” Lew said.
The point Lew and other financial market analysts tried to get across at the time is that investors looking to lend the United States money by purchasing Treasury securities will look at the entire picture of the government’s finances before they decide what sort of interest rate they are willing to accept.
If the Treasury is paying bondholders but stiffing federal contractors, bond investors will take notice.
It’s like a credit card issuer looking at a new application. If the potential customer has another credit card and makes the required payments on time, that’s certainly a point in his favor. However, if that same potential customer is in default on obligations to other kinds of creditors, there’s going to be a strong assumption that lending to him is riskier than his credit card account alone might indicate.
Promises from the Treasury to continue to make good on debt obligations sound nice, but the impact of defaulting on one part of the government’s debts to satisfy others would have a major impact on the government’s credit rating and, as Lew pointed out in 2013, could impact the economy for generations.
“The United States should not be put in a position of making such perilous choices for our economy and our citizens,” he said. “There is no way of knowing the irrevocable damage such an approach would have on our economy and financial markets.”