Joe Biden’s debt ceiling challenge: appeasing the bond market

So here it is: another debt ceiling crisis.

This is the fifth standoff I have covered as a reporter. There was a big one in 2011, of course, but then the 2013 standoff related to Obamacare, the low-profile standoff in 2015, and the 2021 war that requires temporary changes to the Senate filibuster. I am 32 years old. When I say to myself in the mirror every morning, that is not old. And I’m in the fifth debt ceiling crisis. It has all happened before, and it will happen again.

The best solution to the conflict between President Joe Biden and the new Republican majority in the House is for the latter to just give up and pass legislation that cancels the debt ceiling, or at least raises it without strings. House Speaker Kevin McCarthy clearly won’t do that; he got a special speaker by promising the most irresponsible member of the caucus that he would hold the debt ceiling hostage. But past speakers in office, most notably John Boehner in 2013, have blinked and kept passing “clean” debt ceiling bills. I hope he does the same.

The worst solution to the standoff is for the federal government to default: stop paying interest on loans, or pay programs from Social Security to the military, sending the economy into recession and the world into a financial crisis.

Somewhere in the middle are the two most likely outcomes. One is for Biden, like President Barack Obama in 2011, to come to the table and complete a deal with McCarthy for an increase in the debt ceiling in exchange for spending cuts. This would avoid a recession but could mean cuts to important programs from education to health research, which could have long-term negative consequences.

The last option is for Biden to use executive action to create a debt ceiling. There are several ways for him to do this, which I will cover in this section. The funniest thing is printing platinum coins worth hundreds of billions or trillions of dollars. The most boring thing is to issue new debt to finance the government. Somewhere in the middle there is a choice to ask for the 14th Amendment and claim the debt ceiling is unconstitutional, or to claim that according to Congress that previously passed spending and tax legislation forcing the president to ignore the debt ceiling, which some experts consider at least unconstitutional choice.

The debate about the choice is often a discussion of the arcana of law and political perception: will it look bad for Biden to seize this kind of power? Would it seem ridiculous to mint trillion-dollar coins? And while the legal and political details are important, I think much of the discussion about these options presents the biggest challenge: the bond market.

The bond market challenges the debt ceiling

“I used to think that if there was reincarnation, I’d want to come back as the president or the pope or a .400 baseball hitter,” political consultant James Carville once quipped. “But now I want to come back as the bond market. You can scare everyone.”

Bond traders obviously love the quote, but it’s not just gas for their egos. Modern governments rely on the international bond market to finance themselves, and while the government’s control of its currency provides protection from market fluctuations, this power is hardly absolute. History is full of cases of governments being forced to abandon their policies due to bond market revolts. Just a few months ago, mass selling by currency and bond traders forced the Tory government in England to abandon plans for massive deficit-ballooning tax cuts and Chancellor of the Exchequer Kwame Kwarteng, before Prime Minister Liz Truss herself was forced. to resign after only 45 days in office. Banks like Citigroup have openly stated that if the UK does not get a different prime minister, the market will continue to punish.

We know how the bond market responds to routine increases in the debt ceiling unrelated to other policies: nothing. At first, the debate on the debt ceiling in October and December 2021 increased, contested but not in doubt due to the Democratic control of Congress, did not lead to a major change in the interest demanded by investors in short, medium, and long-term Treasury bonds . Yields on these bonds have not risen as the debate has dragged on.

We also know how the bond market responds to the debt ceiling standoffs are actually dangerous, even if they end up succeeding in the ceiling being increased. The Government Accountability Office estimates that the 2011 war, which is coming indeed close to disaster, raising interest rates enough to cost the Treasury $1.3 billion in 2011. That’s okay, but it’s quite small in the plan of the federal budget. The biggest cost of the show is the budget cuts made in the Boehner deal and the Obama cuts.

What is not known is how the bond market will respond to Biden making debt ceiling history, whether through platinum coins, or invoking the 14th Amendment, or some other way. I certainly don’t know, but people who are more experts than me don’t either. “I’ll stick with the answer, ‘I don’t know,'” Shai Akabas, director of economic policy at the Bipartisan Policy Center and an expert on the debt ceiling, told me. Unpredictable market reaction, he said, “has been the biggest concern about all these approaches, not that the substance will create a huge economic disruption.”

David Kamin, NYU law professor and former senior economic adviser to Biden, have said the same: if Biden declares that he does not pay attention to the debt ceiling, “Republicans will certainly scream that he is acting illegally and that the debt issued beyond the limit is illegal. … it is conceivable that the market can react badly – and raise interest rates on Treasuries. Coin minting can have the same result.Kamin doesn’t say this will happen: only that we are in a truly uncharted territory and that’s it can bite

If that just means inflation-adjusted interest on five-year Treasury bonds, say, 1.42 percent to 1.75 percent (to use the GAO’s higher estimate of what happened in 2011) … honestly, that looks good. It’s not huge but it will be a small price to pay to end the debt ceiling.

But the freakout will last longer than in 2011. The issue will go to court. Some lower courts may go against the Biden administration, which would make the market more volatile. The Supreme Court may rule against the administration, declaring that the bond payments because they say they will ignore the debt ceiling are illegal. This can lead to very high interest rates, as investors know some of the bonds they own may have been issued illegally and may not pay off.

And not just government debt! Economist Filippo Gori has seen how the crisis of 2011 affected the cost of loans not only for the government, but for the banks. They found that about half of the increased cost of borrowing was passed on to banks. And if bank interest rates go up, everyone’s interest rate goes up. Other businesses borrow money from banks, and banks will only lend money if they are profitable, which means banks have to charge more than they pay to borrow the money they lend. So suddenly everyone’s interest rate goes up. The Federal Reserve sometimes increases interest rates (as it has in recent months) specifically to get people to spend less money and slow the economy. The debt ceiling crisis could have the same effect, and possibly even more. It’s easy to imagine this leading to a full-scale recession.

This is not a problem unique to ideas like the 14th Amendment option or printing coins. If the US will issue the debt ceiling and the Treasury chooses (as prepared in the Obama years) to “prioritize” payments, pay interest on the debt and some selected government programs, but cannot issue trillions of government bills, the bond market will almost certainly will be nuts. If the Treasury stops paying interest on debt, and defaults, that will be as bad or worse. Compared to these options, basically anything from printing coins to issuing new types of debt is preferable.

I also think this is a risk worth taking relative to the option of making spending concessions for House Republicans. The trillion dollar spending cuts implemented in 2011 are dangerous. They hurt millions of real people first. They undermined our ability to prepare for a pandemic, before the worst pandemic in a century. Worst of all, he taught congressional Republicans that they could take the debt ceiling hostage and get big concessions, a lesson they are now doing. The only way to break that precedent and prevent the ceiling from being used as a hostage for decades is to end the debt ceiling — by law if possible, by fiat if necessary. You have to take hostages.

But I think that advocates of the option, like myself, should think seriously about how to answer the challenges of the bond market. I can imagine Biden and his advisers making a choice between a deal with McCarthy and like printing coins, and it will not be the former because there is less risk in the bond market, and therefore there is less risk of crisis and recession. I think it’s wrong, but it’s true that making a spending deal will have predictable consequences in this regard. The 2011 deal did a lot of damage but did not cause a recession, which would have made it worse.

Convincing the administration to take another path requires figuring out some way to reassure the market after Biden repeals the debt ceiling, and to prevent the legal risks inherent in the move from causing an economic disaster. I don’t know how to do it myself; If it were me, I would say something. But fortunately there are many people who know this market better than I do who can hopefully work on ways to make this option more attractive to the administration. If Biden doesn’t persuade, we could be looking forward to another decade of spending retrenchment and the impending debt ceiling crisis.