Pat Toomey. Image via Wikipedia
Megan McArdle and Matt Yglesias are having a bit of a discussion about whether this is actually a way to avoid default or just to engage in a different kind of default. Yglesias writes:
McArdle responds with two points. The first is that the government failing to make certain kinds of payments would just be a change in policy, not a default. She notes that Social Security is not contractual and the government can simply change benefit levels at will. Other examples are even better: if running out of money causes the government to cancel certain capital projects, that's not a default, it's just not building something you had planned to build.Now of course this is nonetheless a kind of default. A person whose creditworthiness is above question meets all his financial obligations. Another kind of person might manage to stay current on his mortgage and make minimum credit card payments while leaving utility bills unpaid and welching on sundry promises to friends and business associates. That's not grounds for foreclosure, but obviously it's going to hurt your standing as a borrower.
The second is basically that the bond market only cares about getting what it's due, and is likely to overlook actions by the federal government to stiff other creditors--indeed, bondholders might like such actions, as they show that bondholders are the senior creditors:
The first thing a lender wants to know is not whether you are a good person, but whether you are likely to repay the money they lend you; they are interested in the former only insofar as it implicates the latter... if the government misses a debt payment, that's it for borrowing more money in the near future... that means we immediately have to balance that budget, and keep it balanced... Over the long run, if the credit taps get cut off, the social service cuts will be deeper, uglier, and permanent.
A key thing here is that there are two kinds of defaults: one where you're going to pay late, and another where you're going to pay never. An impasse over the debt ceiling could lead to the former kind of default; it would not mean that the U.S. government lacked the willingness or wherewithal to pay its obligations ever. If you're just going to be late, it absolutely makes sense to allocate the late payments to the creditor who's going to squeal least about being paid late--which is to say, not bondholders.
Similar prioritization is already routine at the state level, as I've written in the past. Illinois has this down to an atrocious science, managing its cash position by running up multibillion dollar backlogs of late payments to Medicaid providers and local governments. Other states do it on a smaller scale: California was sending IOU payments to state workers for a time in 2009; quite a few states have delayed issuance of tax refunds to avoid running out of cash. Importantly, none of these states have made noise about defaulting on General Obligation bonds, even though they are at the state-level equivalent of hitting the debt ceiling.
It's worth noting that while paying bondholders first is routine fiscal practice around the country, an equivalent to the Full Faith and Credit Act is actually written into California's state constitution, which states that the obligations to pay debt service and aid to school districts are pari passu, and senior to all other financial obligations of the state government.
Yglesias and McArdle agree that the best policy solution is for the federal government to raise the debt limit and meet all of its financial obligations. I agree, too--even if we don't get a debt crisis, failing to make non-debt service payments would be seriously disruptive to the economy: think states not receiving federal matching grants, Medicare providers going unpaid for services rendered, Social Security recipients not getting checks they need to pay living expenses. It's not a good way to manage the budget.
But I also agree with McArdle that this is a better option than stiffing bondholders, and that the Full Faith and Credit Act would therefore make a debt limit impasse less damaging to America's credit--which is not to say there would be no damage at all. Again, it's instructive to look at the states.
Illinois, which makes the most use of the sort of fiscal triage that the FFCA would allow, pays the highest bond spreads of any state in the country. The effect Yglesias hypothesizes is real: Illinois's poor overall fiscal management is making bondholders demand a higher risk premium, even though the state has prioritized bondholders over other creditors. But Illinois still has access to the bond markets at non-astronomical rates--this presumably would not be the case if the state actually stopped making payments on bonds.
I will grant one possible concern: that a law like FFCA would make debt limit standoffs less scary, and therefore more likely, ultimately making the U.S. look like a less responsible borrower. I think that's probably not the case--even without FFCA, the Executive Branch has a number of tools to manage when it hits the debt cap, including disinvesting federal trust funds and even selling gold reserves. But it's a point worth pondering.
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