Many are predicting a financial disaster if the U.S. Congress fails to raise the debt ceiling by October 17. Given the political volatility around the issue and the current government shutdown, a catastrophic outcome cannot be ruled out. But a deep financial crisis is unlikely, because President Obama and the Treasury Department have many levers available to help them avoid worst-case scenarios, at least for the near term, says Wharton finance professor Franklin Allen in this podcast interview. Allen is co-editor of the recent book, Is U.S. Government Debt Different?
An edited transcript of the conversation appears below.
Knowledge at Wharton: We’re speaking today with Wharton professor Franklin Allen about the potential U.S. government default on its debt around October 17. Professor Allen is the co-editor of a recently published book entitled Is U.S. Government Debt Different?, which was published by the Wharton Financial Institutions Center and is available for free on its website. It’s a collection of essays written for exactly this kind of a potential crisis.
Franklin, thanks very much for joining us this morning.
Franklin Allen: It’s my pleasure, thank you.
Knowledge at Wharton: It appears the government shutdown issue is merging with the debt ceiling issue to create the mother of all debt confrontations. As we know, the U.S. government is set to run out of money around October 17 unless the debt limit is raised. So, putting the politics aside for now because they are, at best, murky, and based on the Wharton seminar on which your book is based, what do you think are the best-case and medium-case and worst-case scenarios for the outcome of this potential crisis?
Allen: Well, the best case scenario is that they do the deal and we’re finished with this in the next day or two. But I think that that’s unlikely to happen.
I think that the medium scenario is probably that this goes on for some time to come. I think the shutdown probably isn’t so damaging, especially since I understand that the Pentagon is sending 350,000 people to work, so that’s reduced the total significantly. But as the process indicates, the real action so to speak is in the debt ceiling and one of the interesting things that I think we learned from this conference is that there are ways for them to avoid default and I think that there are good reasons to do that. There’s a very interesting chapter in the book, Chapter Five, by professor Michael McConnell from Stanford University, which goes into the debt clause of the 14th Amendment and this is a part of our Constitution that says, to abbreviate it, the debt of the United States as it’s legally issued shall not be questioned.
“… What the politicians are trying to emphasize is this worst-case scenario although, I think myself, it’s fairly unlikely it will play out that way.” — Franklin Allen
Now there is an issue about what does that mean? But essentially, it is difficult for the government to avoid [making payments] or to default, because if there was any sense of that, even a technical default, I think that there would be constitutional issues raised and that would be difficult for the government. In Chapter Six, by professor Howell Jackson from Harvard University, he goes through scenarios about how the government can avoid default on the debt and essentially, what seems likely to happen if they don’t raise the debt ceiling and we go through that period up to the 17th … where the government can’t borrow anymore. Then, what’s likely to happen is some kind of modified first-in, first-out [an accounting bill-paying system] whereby all of the bills that come into the government will be placed into a pile, so to speak, and then as the money comes in from the tax revenue that will still be collected, then they’ll pay the bills that are at the top of the stack.
Now what happens, of course, since they can’t borrow and that pays a substantial part of our expenditures at the moment, is that the time it will take for people to get paid lengthens. They can prioritize various things and they can, in particular, prioritize the interest payments, so there’s no reason that we need to have a default. There’s plenty of tax revenue to cover the interest and so what will happen is that people will get paid, but it will take longer and longer, and I think the interesting question will be how the Treasury deals with that, whether they will try to send Treasury people to explain when they’re likely to get paid and whether they can take those [promises] to banks and borrow against them and so on. I think there’s little doubt that these people will eventually all get paid. The only issue is the timing of it. So I think that’s the medium scenario, which is that we can go on a fairly long time without the debt ceiling being raised.
The worst-case scenario is that there is a default and then I think it’s very uncertain how things will play out. A lot of the legal issues will be quite incendiary and difficult to predict and that, indeed, could be very bad. And this is what the politicians are trying to emphasize is this worst-case scenario although, I think myself, it’s fairly unlikely it will play out that way.
Knowledge at Wharton: Some observers note that a failure to raise the debt ceiling would require an immediate cut in spending. So even if there weren’t defaults, there’s a paper out by Bank America Merrill Lynch that says if the debt ceiling is not lifted, then the U.S. would have to immediately cut its budget by about 20%, which is equal to about 4% of GDP. That would push the U.S. into another recession even if there were no default. What would be the consequences for the U.S. and world economies?
Allen: Again, I would put that at the end of the worst-case scenario and again, there’s a lot of uncertainty about how things will play out. If that was to happen, if they had to balance the budget pretty much straight away, there would be a big cut and then that would have big follow-up effects.
“It is indeed possible … to mint up a trillion dollar coin and finance the government that way.” — Franklin Allen
My own judgment would be that there will, in effect, be a form of government borrowing, which is that these payments will be elongated so that if you fell into the federal government [budget], then it’s going to take you a long time to get your money but that they can build into that effectively an interest rate payment and as I say, at some point, I think it’s fairly clear that everybody will get paid.
My understanding is that Congress passed [a measure] over the weekend that all the [federal] workers that are currently on furlough will ultimately be paid. I think that the same will happen with suppliers and the real question is who’s going to provide that credit in the meantime with what is effectively a form of borrowing, although legally it won’t contribute to the debt ceiling, it’s just a delayed payment?
My own guess is that banks and maybe the Federal Reserve will help them do this by providing the liquidity so that they will be able to effectively spread out the payments. But you know, the worst-case scenario is a possibility, certainly.
Knowledge at Wharton: If it happens along the lines of what you’re talking about, it’s a lot of uncertainty. How would the markets handle that? Are they going to sit by idly and say “Well, this is really messy but it looks like it’s all going to work out ultimately so we’re not going to get too rattled?” Or is all of that uncertainty going to lead to problems in equity and bond markets, and perhaps there would be choices made about cutting back on spending in many places? How could that effect growth in the U.S. and the world? Could it tip one or both into recession?
Allen: Certainly in the worst-case scenario, if any of these events — a default or a dramatic cutback in government spending — if any of these things happened, then it certainly can cause a recession and that can spill over not only into a global recession but we could see financial stability problems again … because if there is a recession, the claims that many banks have may not be quite what we’ve valued them at today. So far, we haven’t seen much sign of the markets [reacting] and I think that the current view is that a deal will be done.
I wouldn’t be surprised if it took somewhat longer than the markets expect. I think many people were predicting [the government shutdown] would last a few days, I guess we’ve already pretty much gone a week. There doesn’t seem to be any negotiations or any settlement in sight on these issues. It may well take a longer time.
As we go on more and more, there will be more worrying and the markets will start to react, but it is quite interesting how little they’ve reacted so far in the judgment, at least when you talk to people, that they believe a deal will be done. As I say, I’m not sure that’s necessarily the case but on the other hand, I’m not so sure that it will be so worrying, so badly damaging, if a deal isn’t done. It won’t be good for sure and as things accumulate, it will get a worse and worse effect even in the medium scenario. But it may not be doomsday unless somebody does something which would be perhaps unnecessary, like default or something like that.
Knowledge at Wharton: I see that Goldman Sachs has estimated that a week-long government shut down … would subtract 0.3 three percentage points from GDP in the fourth quarter on an annualized basis. I suppose that you could extrapolate from that and see if it went two weeks or three weeks or something like that, then as you say, the effects would start to accumulate.
“I think one of the reasons there’s so much intransigence is the realization is that there isn’t Armageddon out there unless somebody makes a mistake.” — Franklin Allen
Let me ask you about an idea that is put out there from time to time that I don’t think people understand very well and that’s the idea of minting a trillion dollar platinum coin to create new cash reserves. I know that that sounds a bit gimmicky at first, but then some would argue that shutting down the government and threatening defaults are extreme and unprecedented measures that might require unprecedented responses. It’s also true that the treasury creates money out of thin air every day by selling bonds and so forth. So is the idea of a trillion dollar platinum coin really so different in principle? And maybe you want to explain how that would work a little bit also.
Allen: This was discussed a little bit at the conference. There are various technical ways of getting around these limits, and under the debt limit, coins are not included [as being prohibited]. So it is indeed possible, apparently, to do that, to mint up a trillion dollar coin and finance the government that way. My own view is that they probably won’t do that. There are various other things that they can do apparently depending on the technicalities of who actually owns the gold — the Federal Reserve or the Treasury — and there’s a split between those. So there are several of these kinds of gimmicky things that the government could do. My guess is that they won’t resort to them. They said they won’t and it’s difficult to know what exactly they will do, but I would be surprised if they did any of these things.
Knowledge at Wharton: What other important things would it be good to understand about the situation that we’re in that maybe isn’t immediately apparent to observers?
Allen: I think the most important thing, which I think the press hasn’t done a very good job of doing (because there isn’t that much research on how this situation will play out, though there is now much more than there was in August 2011) is that we don’t have to default. And the incentives are, at the beginning, to say that we are going to, so they [the press] do think these doomsday scenarios are something among the politicians, but not necessary that we have to do it. It may happen, but we don’t have to do that, and that we do have this debt clause [the 14th Amendment], which does say that the debt of the U.S. government shall not be questioned.
I think that is a factor that isn’t being discussed enough in the press and also this issue of “first-in, first-out,” [accounting procedure] and also the pressure to go back and look at what other governments and other administrations have said when faced with questions about these kinds of issues in the past, which is done in the the appendix of the book. There is a very nice section by Howell Jackson and two of his students at Harvard in a very careful way about previous statements about these things.
Knowledge at Wharton: So what you’re saying is, despite the politics and despite the confrontation, and even if there is no compromise between the two sides, there are still various avenues for the active government behind the scenes to avoid a default — at least for some reasonable period of time. Is that correct?
Allen: That’s my view, yes. And one of the interesting factors is I think both sides know, and I think one of the things that Republicans have tried to do, is to pass these laws to prioritize the interest so that that would happen by a statute. It didn’t get through both houses of course but I think one of the reasons there is so much intransigence is the realization that there isn’t Armageddon out there unless somebody makes a mistake.
It may happen that we end up with a terrible situation. But it needn’t work out that way and I think that’s made both sides prepared to take a harder line than they were prepared to in the past, and why we’re going down this road. If you’d gone back a week, most people didn’t expect we would be where we are today with very little movement on either side. It will be interesting to see where we are another week, another month from now.
Knowledge at Wharton: All right, thanks very much for chatting with us today. I’m sure we’re all looking forward to seeing how it works out.
Allen: Let’s hope it works out. Let’s hope the good scenario works out quickly, but somehow I doubt it at this stage.
