CORRECTED & UPDATED: Thanks to Josh Barro: Debt Ceiling: What Are þe Fallback Threat Points in þe Case of "No Deal"?

Walking down the strategy & scenario tree...

Let me first say that the United States Treasury is very unlikely to start writing rubber checks.

But what would happen if it did write rubber checks will shape whatever the settlement of the current debt ceiling crisis, turns out to be.

However, what will determine the settlement is what people believe that the threat points are—not what the threat points actually are.

My problem is that I do not know what people think the threat points are. All I know is (a) what I think the threat points are, and (b) that a great many of the people who matter do not understand the threat points.

So here, for whatever it is worth, is my understanding of the threat points:

---

Treasury Secretary Janet Yellen says that soon after June 1 the US Treasury will start bouncing checks:

• People will deposit the checks the US Treasury has written, paper, or electronic, in their bank accounts.

• The banks will then attempt to clear them.

• But the Federal Reserve will say: if we clear this check, it will push the Treasury's balance at the Fed below zero.

If we reach that point, I see one of three things happening:

1. The Federal Reserve might simply record a negative balance in the Treasury account. It would then start writing the Treasury the letters that Mechanics Bank writes to me occasionally, letters about how—as a courtesy—they have honored my rubber check, and now—as a courtesy in return—will I in return please pay them the extraordinary penalties and interest outlined in subparagraph 93.

2. The Federal Reserve might tell the banks that it can't clear the checks, and you need to take matters up with the Treasury. The banks might then say: your Treasury check has bounced, but do not worry, we have credited your account, anyway, and will handle this, and please be very grateful to us.

3. The Federal Reserve might tell the banks that it can't clear the checks, and you need to take matters up with the Treasury. The banks might then say: your Treasury check has bounced, and you need to take matters up with the Treasury.

Whichever of these three possibilities comes to pass, it is hard to see Treasury securities not going to some kind of discount to their normal values in the aftermath.

Indeed, it has already started: the prices of Treasury securities coming due in early June are, right now, interesting.

Now why might the Treasury start writing rubber checks?

The way it has been explained to me is this:

• The laws Congress has passed tell the Treasury to write checks: the Treasury has no discretion.

• The laws Congress has passed tell the Treasury to levy taxes

• And the Treasury borrows to make up the difference.

• But Congress has also passed a law—the debt ceiling—commanding the Treasury not issue bonds with total face maturity values above the debt ceiling.

• The Treasury has no choice but to obey all of those laws.

• Obeying them all will, in early June, require it to write rubber checks that will bounce.

You are saying: This is really weird.

And you are right.

---

But I think gets weirder.

The law also makes the Treasury Secretary a fiduciary who manages accounts separate from the main Treasury account: the Social Security trust fund account and the government employees thrift savings plan account, to name two.

The government securities held by these two accounts are, if I recall correctly, bespoke: They, daily, pay the average interest rate on outstanding government debt. But they can be redeemed any day at par.

Earlier this year the Treasury Secretary redeemed these securities, but she did not transfer any cash from the main Treasury account into the trust funds accounts.

She thus transformed the interest-paying full-faith-and-credit securities held by these trust funds into a zero-yielding sketchy unpaid-debt IOU from the Treasury. This is not what a fiduciary does—to take steps that stop the flow of interest into managed accounts. In disinvesting these trust funds, the Treasury Secretary has broken the law that requires her to act as a fiduciary. Laws have already been broken—or, at least, not faithfully executed—here. You can shrug and say that Biden will not be impeached over this, that it is Biden’s business to take care that his subordinates faithfully execute the laws, and that this is no biggie. But why is the Treasury Secretary’s breaking the law requiring to act as a fiduciary a smaller deal than the Treasury Secretary’s issuing securities above the debt ceiling? Why is one of these an ironclad rule and the other only a “guideline”, as Captain Barbossa says in Pirates of the Caribbean?

---

CORRECTION & UPDATE: Josh Barro has the answer. He writes:

Redemption of the securities in the G-fund during a "debt issuance suspension period" is authorized by legislation passed in 1986, following the debt ceiling crisis of 1985, in which then-Treasury Secretary James Baker had raided the Social Security Trust Fund in order to avoid missing interest payments on the debt.

There was a GAO report following the 1985 crisis saying essentially that what Baker did was probably illegal, but understandable under the circumstances. The 1986 law was intended to make matters more orderly, saying how the funds could be raided and how they needed to be made whole once the crisis was over -- and, crucially, saying that the Social Security Trust Fund may not be raided, which is why that's not included in extraordinary measures.

So the items Rubin picked off the menu in 1995 were driven by the 1986 law; they weren't arbitrary. The Bipartisan Policy Center has a useful history of the debt limit; you can see this in the entry for 1986….

I do think people are not focusing enough on the 1985 precedent -- what Baker did was wacky and of dubious legality but it was way better than defaulting. Indeed, it went sufficiently smoothly that nobody even remembers it…

---

I have never found anyone to explain this to me, or to say anything other than: "Well, Bob Rubin did it in 1995, so there is precedent and it is OK.”

But in every real sense, the debt of the United State—outstanding securities, plus these zero-yielding IOUs owed to the trust funds, which nobody denies are debts of the United States—now exceeds the debt ceiling and has done so for months.

The Treasury says that it has not broken the debt ceiling law because these IOUs are not part of the debt subject to limit. While the debt ceiling was clearly intended to be a ceiling on, well, the debt. It was not terribly well drafted. It defines the debt subject to limit as consisting of issued Treasury securities counted at their maturity or redemption value. Thus, the Treasury says, unpaid IOUs that do not have a formal issued security attached to them do not count.

But the Treasury further says that it has now exhausted all of its debt-ceiling wiggle room: that there are no further “expedients”. And so it reaches the conclusion that because it will not break the debt-ceiling law—which is a rule, as opposed to the requirement that the Treasury Secretary act as a fiduciary, which is only a guideline—it will be forced to start writing rubber checks in early June.

Are you confused by now? Good. You should be.

For at this point many get off the bus, and say: That makes absolutely no sense!

The Treasury:

• has the legal power to issue securities with high coupons that have initial market value greatly in excess of their maturity value. That would allow the Treasury to borrow a lot, while raising the debt-subject-to-limit value by only a little. Issue a $10,000 Treasury bond with a 100% annual coupon, and you can sell it for about $95,000. Thus the Treasury can borrow much while only raising the total face value of the debt subject to limit by a little.

• could issue consols—perpetual securities that pay fixed coupon values as long as the United States have last—that have maturity or redemption value at all, and so add zero to the debt subject to limit.

• has the legal power to coin platinum coins of any denomination, with fiat legal-tender values that are not tied to the market value of the platinum in the coin. The $1,000,000,000,000 coin. (Or 10,000 $100,000,000 coins.)

When people say “expedients are exhausted” they mean only that: “those expedients of which Bob Rubin made use to during the Gingrich debt-ceiling crisis of 1995 have been exhausted”.

If all of this is unclear and confusing, congratulations: you are a rational human being.

But a CDS on a one-year U.S. Treasury note reached a peak value of 60 basis points in late 2008. It is now at 150 basis points. This game of dingbat kabuki is already having real effects on asset prices.

But the overwhelming bulk of opinion of asset holders is that this game of dingbat kabuki is a distraction: stock index values like the S&P500 remain rock-solid.

---

Back up: what is really going on?

At one level:

• (a) Speaker Kevin McCarthy is saying: the House has passed a bill raising the debt ceiling that had, attached to it, a number of policy changes. If the Senate and the President want to avoid bouncing checks, they will pass and sign that bill. Or maybe they have a counterproposal as to what policy changes they wish to see?

• (b) President Joe Biden is saying: holding the faith and credit of the United States government hostage in order to try to exact policy changes is no way to run a government. And Biden is saying: Kevin, you are only doing this is because the 40 craziest members of your caucus think this is a way they can gain credit with their base.

At a deeper level:

• (a) Speaker Kevin McCarthy's caucus thinks it is a political winner to stand up against excessive debt and they can frame the issue that way, and

• (b) President Joe Biden and the Democrats think it is a political winner to stand up for normal functioning of the financial system, and for the United States's "full faith and credit" to mean something, and they can frame the issue that way.

At most one of these is right. It may well be the case that both are wrong. Since all should agree that there chances of winning from this or less than 50%, they should have reached agreement by now. It is collectively irrational for this to continue.

So why haven’t they reached agreeement? What is it that makes this sort of thing dangerous?

What makes it dangerous is that the press will, after this is over, say that one side "won" and the other side "lost". That judgment will matter. Thus even if it turns out both to be a political loser to "stand up against excessive debt" and to be a political loser to "stand up for 'full faith and credit'", there will still be a net winner from engaging in this mishegas unless the press can be nudged into saying "both sides lost", because this is America, and being a winner is good whether or not what you actually “won” is simply a steaming pile of dogshit.

---

Are you familiar with the dollar auction?

It's a thing done in game theory classes. The teacher auctions off a dollar. The high bidder pays, and gets the dollar. The trick is that the second bidder pays also—but does not get the dollar.

When you hold a dollar auction, there is always one student who cannot resist bidding one cent, and another student who cannot resist bidding two cents, and on the thing goes until someone has bet 49 cents and someone else has bid 50 cents.

At that point the game should change: the 49-cent bidder should look at the 50-cent bidder and think "if I bid 51 cents, then the two of us are losers here and the teacher is the winner; this is not a good game to be playing; I should drop out". But they also think "if I bid 51 cents, then the other bidder will recognize that this is not a good game and drop out, and I will clear 49 cents".

Usually the bidding continues.

There may be another pause to think when someone bids a dollar. Then the bidders are bidding not for a gain for themselves , but in the hope of reducing their loss—by a dollar.

In this game, there are two strategies that in game-theoretic equilibrium avoid loss: (a) never bid, and (b) be the first bidder, and bid $1 (although that is a risky strategy if there is a Bozo the Clown out there: better simply not to bet). Yet, if everyone plays the first strategy, there is 99 cents left on the table for the guy willing to make an initial bid. So everybody playing strategies that avoid expected loss is not an equilibrium.

The more general lesson is this: When people value "winning" for its own sake, things get crazy quickly.

So here we are.