Wednesday, July 20, 2011

Fiddling While Rome Burns

If there was ever any historical truth to the report that the Emperor Nero played his lyre while the main part of Rome was destroyed by fire in 64 A.D., then we should count ourselves unlucky to have to witness the same insouciance taking place before our eyes today. While the politicians in Washington dither and fume, President Obama is playing a game of Twenty Questions with them, forcing them to guess what mix of measures he would favor (think: higher taxes) and spurn (think: spending cuts today), without putting forward any specific proposals himself. Meanwhile, the government's insolvency looms closer and closer, when the Secretary of the Treasury's last shell game will run out of peas to shift around.

With the authorization of Congress granted in 1986, the Treasury since last May has been creating some "breathing space" below the debt ceiling by robbing cash and previously purchased Treasury securities from specific government funds which are required by law to invest their receipts in such securities: the Civil Service Retirement and Disability Fund is one such victim, and the Government Securities Investment Fund ("G-Fund") is another (scroll down the previous link).

The purpose of appropriating the cash receipts of these funds is obvious: when their cash is used to pay bills, instead of purchasing more Treasury securities, it keeps Government debt from increasing pro tanto. And when the Treasury takes securities from these funds and sells them to third parties for cash to pay its current bills, it is also thereby reducing the total amount of Government debt outstanding. By selling hundreds of billions of dollars' worth of the securities in the weeks since May 16, when he announced the commencement of his juggling operations, and by appropriating the funds' incoming cash, Secretary Geithner has been able to pay all of the government's bills as they fell due, without exceeding the total debt limit established by Congress.

However, all such shell games must eventually come to an end, and this one is no exception. The wizards at Treasury were able to forecast in May (see the previous link) that even by robbing the trust funds, the Government's outstanding bills would exceed the Government's ability to borrow more cash to pay them by August 2. That date, confirmed in an announcement on June 1, thus became the much-touted "Financial Armageddon" about which one has been reading so much lately.

With the wonders of the Internet, now you can play "Treasury Secretary" yourself, see just what bills you will face on August 2 (about $306.7 billion), how much cash you will be receiving with which to pay them (about $172.4 billion), and make your choices accordingly. Bloomberg has put up a very helpful interactive chart to illustrate the choices, and I encourage you to try it out. You will learn more there in a few minutes about the government's financial operations than you will ever learn by listening to statements from and speeches by politicians.

Secretary Geithner has helpfully spelled out what he sees would be the consequences of failing to raise the debt limit by August 2 in this letter he wrote on May 13, 2011 to Senator Michael Bennet:

As you know, the debt limit does not authorize new spending commitments. It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past. Failure to raise the debt limit would force the United States to default on these obligations, such as payments to our servicemembers, citizens, investors, and businesses. This would be an unprecedented event in American history. . . .

A default would call into question, for the first time, the full faith and credit of the U.S. government. As a result, investors in the United States and around the world would be less likely to lend us money in the future. And those investors who still choose to purchase Treasury securities would demand much higher interest rates . . .

Default would not only increase borrowing costs for the Federal government, but also for families, businesses, and local governments - reducing investment and job creation throughout the economy. Treasury securities set the benchmark interest rate for a wide range of credit products, including mortgages, car loans, student loans, credit cards, business loans, and municipal bonds. Accordingly, an increase in Treasury rates would make it more costly for a family to buy a home, purchase a car, or send a child to college. . .

. . . Additionally, a default would substantially reduce the value of the investments - including Treasury securities - held in 401(k) accounts and pension funds, which families depend on for their retirement security. This significant reduction in household wealth would threaten the economic security of all Americans and, together with increased interest rates, would contribute to a contraction in household spending and investment.
Had enough doom and gloom yet? He's still not through sketching the consequences:
The unique role of Treasury securities in the global financial system means that the consequences of default would be particularly severe. Treasury securities are a key holding on the balance sheets of virtually every major insurance company, bank, money market fund, and pension fund in the world. They are also widely used as collateral by financial institutions to meet their day-to- day cash flow needs in the short-term financing market.

A default on Treasury debt could lead to concerns about the solvency of the investment funds and financial institutions that hold Treasury securities in their portfolios, which could cause a run on money market mutual funds and the broader financial system - similar to what occurred in the wake of the collapse of Lehman Brothers. As the recent financial crisis demonstrated, a severe and sudden blow to confidence in the financial markets can spark a panic that threatens the health of our entire global economy and the jobs of millions of Americans.

Even a short-term default could cause irrevocable damage to the American economy. Treasury securities enjoy their unique role in the global financial system precisely because they are viewed as a risk-free asset. Investors have absolute confidence that the United States will meet its debt obligations on time, every time, and in full. That confidence increases demand for Treasury securities, lowering borrowing costs for the Federal government, consumers, and businesses. . . A default would call into question the status of Treasury securities as a cornerstone of the financial system, potentially squandering this unique role and the economic benefits that come with it.

Moreover, the fact that the United States would not have enough money to meet all of its obligations would have serious economic consequences. If the United States were forced to stop, limit, or delay payment on obligations to which the Nation has already committed - such as military salaries, Social Security and Medicare, tax refunds, contractual payments to businesses for goods and services, and payments to our investors - there would be a massive and abrupt reduction in federal outlays and aggregate demand. This abrupt contraction would likely push us into a double dip recession.
There is no question that we should avoid the consequences of bumping into the debt limit -- they will truly be unpleasant for everyone. But the real questions are: How did we get ourselves into this situation? And what must be done to get ourselves out of it?

Secretary Geithner hinted at the answer to the first question when he wrote: [The debt limit] "simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past." (Emphasis added.) Our politicians, for various historical reasons, have always concerned themselves with current spending, and have left it to the Treasury to worry about the sum total of what year-to-year current spending adds up to. This has forced the Treasury to borrow money almost from the very first day of the Government's existence, as sketched in this earlier post.

There was only one day in our country's entire 222-year history when there was zero Government debt outstanding -- that historic date was January 8, 1835. President Jackson's resolve to stop government borrowing, however, was hijacked the very next day, when the Treasury had to issue new notes to pay bills that had accumulated from prior approved spending, because there were not enough cash receipts on hand.

And it's been like that ever since. Congress and the President are continually spending money which the Government does not have through its cash flow. The problem is that, although they have said each year they were establishing a budget, the budget gets overtaken by events, or else it was not accurate in forecasting receipts or expenses -- or whatever. So budgets came to be looked upon as just "guesstimates", while the limit on government borrowing had been set by earlier laws (back when the government tried to do things right). When the first debt ceiling was reached, Congress obligingly bumped it up a notch, and it's been doing so ever since.

So the first step toward remedying this problem is to implement zero-based budgeting, and to stop projecting steady increases in authorized spending over the previous year's levels.

The next step is to adopt a balanced budget amendment, which will prohibit Government from relying on borrowing to finance its current expenditures. Borrowing will revert to its original purposes: to finance capital outlays for infrastructure improvements, wars and national emergencies, and similar situations for which current cash flow is inadequate. And it would be managed just as any other business does it: debt would be kept below a level where the cost of servicing it robs too much of current income. Passing such an amendment will be a true test of integrity -- past attempts have been sabotaged.

But the real substantive step would be the systematic elimination of Government waste and fraud. Hundreds of billions, if not trillions, could be cut from spending if there were some kind of accountability measures put in place. (And the best way of all to do this would be to make all government employees and contractors self-accountable -- that is, it would be in their own best interest to minimize government waste and fraud. But that's a subject for a separate post.)

Finally, the Heritage Foundation has provided a helpful checklist of other measures necessary to get the government debt monster under control.

So that is the conventional answer to the questions posed above. I am pessimistic about the chances of such common sense ever descending upon our elected officials before time -- and money -- run out on them. They will continue spending and wasting our money as they always have, until the very disasters which Secretary Geithner so vividly portrayed will be forced on them by ever-increasing borrowing.

When lenders stop buying Government securities because of a fear they will never be repaid, or will be repaid in worthless dollars, then the Government will have to sell its securities to itself -- as it already has started doing, in spades. And when that becomes the Government's only source of funds, we will drown in a sea of paper dollars, and inflation will destroy any shred of meaning the dollar has left.

So raising the debt limit once again by August 2 is a virtual certainty; the only question is what accompanying measures can the Republicans force on the Democrats that will begin to reverse the current trend. If the measures are just more toothless promises, then long-term death by debt becomes that much more certain a future. Sic transit gloria Americae.


  1. Thanks for this post. Good food for thought!

  2. Mr. Haley,

    Excellent article. And how apt the title, being published just two days after the anniversary of the beginning of the "Magnum Incendium Romae," which began on 18th July of AD 64.

    Pax et bonum,
    Keith Töpfer