The gridlock over the debt ceiling continues in Washington and shows few signs of abating. Many parties are weighing in publicly on what happens with federal spending and allocation of financial resources if the Treasury finds itself having to decide what gets paid and what doesn't get paid.
The most disturbing part of this discussion is the lack of consensus being offered publicly by the largest financial institutions. Investors should find this very worrisome because the issue is mostly mechanical, with few subjective decisions allowed for by the President, the Congress or the Treasury Secretary.
The most prominent of these issues is whether the Treasury can prioritize what gets paid and what doesn't. Not only can the Secretary of the Treasury prioritize payments, he is required to do so.
The President is the chief executive officer of the federal government. The Treasury Secretary is the chief financial officer. Although the Treasury Secretary reports to the President as the Treasury is part of the executive branch of the federal government, he has a legal obligation to pay the financial obligations of the U.S. government to the extent that he has the ability to do so. I discussed this last week.
The first priority is debt service on the publicly-traded debt. This is absolute and there will be no default on this debt.
The second priority is subjective, however, and gets to the heart of the matter. It involves the servicing of intra-governmental debt obligations, principally to recipients of Social Security and Medicare benefits, as well as to civil and military service retirees. If the debt ceiling is not raised, the Treasury will have to decide on these financial payments vs. the ongoing obligations of paying for current employees and government operations.
It is most probable that the Treasury Secretary will have to decide how to apportion the limited resources available from tax receipts to service these obligations and that in doing so there will be haircuts on both sides.
In dealing with the second priority the Treasury Secretary will also have to decide whether or not to begin to convert the intra-governmental debt obligations of the US government trust funds into publicly
traded sovereign and spend the proceeds to meet the current financial obligations; as I discussed in September in the column,"The Truth About Sovereign Debt."
If you have not read that column, I would advise doing so. The lack of understanding being expressed publicly by the financial institutions with respect to the ability of the Treasury Secretary to liquidate the U.S. government trust funds is disturbing.
I don't know if the Treasury Secretary will begin to liquidate trust fund assets to meet the government's financial obligations, but it is a possibility and investors need to be mindful of it.
The likely course of action is that all publicly-traded debt continues to be serviced while haircuts to trust beneficiaries are reduced. This would mean that Social Security, Medicare and federal retirees receive smaller payments. The next step would be haircuts to the income received by current federal employees and government programs. The next step would be liquidation of trust fund assets.
Beyond those issues, however, the Treasury Secretary could pledge the special debt obligations inside of the government trust funds in repurchase agreements with the Federal Reserve. This could be done in order to raise government working capital, rather than convert the intra-governmental debt to publicly-traded debt.
The issue with doing so, however, is that although this keeps the debt inside of the government it is also not sterilized by definition. This means that it would cause currency in circulation to increase and put upward pressure on interest rates, especially long-end rates.
If the Treasury and Federal Reserve were to choose such a route, the Fed would almost certainly have to counteract the inflation caused by the currency depreciation by implementing even more quantitative easing. That would be targeted at the long end of the outstanding Treasury issues in order to hold down those rates and consumer loan rates by extension.
As the markets begin to become concerned about the Treasury Secretary having to make such decisions, there may be a flight to safety by private investors away from U.S. Treasuries and into alternative assets. I will discuss that in more detail tomorrow.