Treasury’s astonishing statement on US default

By Felix Salmon
January 22, 2011
Four years ago, I started pushing back against the idea that whenever the government fails to make good on some obligation or other, that's exactly the same thing as a bond default.

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Four years ago, I started pushing back against the idea that whenever the government fails to make good on some obligation or other, that’s exactly the same thing as a bond default. Of course it isn’t: bond payments are a very special form of government obligation, involving specific sums of money to be paid in a specific manner on specific days. If you fail to make such payments, you’re in default. If a government takes money from, say, the military-salaries pot and uses it to make its bond payments, then that’s a drastic way of avoiding default. It’s a broken promise, to the servicemembers in question. But it’s not a default.

No one understands this better than Treasury. Just ask Tim Geithner himself, who was undersecretary for international affairs from 1998 to 2001, during the Asia and Russia crises. When he was dealing with sovereign defaults, there was a clear understanding that what mattered for such purposes was whether or not countries made their principal and coupon payments in full and on time. Domestic obligations, while important, were a separate issue — and in many cases the international community, led by Treasury and the IMF, would encourage countries to radically overhaul those obligations. No one at Treasury back then made the argument that such overhaul might itself be tantamount to default.

How things have changed now that the problem is domestic, rather than foreign. Neal Wolin has penned an astonishing blog entry at Treasury.gov:

Adopting a policy that payments to investors should take precedence over other U.S. legal obligations would merely be default by another name, since the world would recognize it as a failure by the U.S. to stand behind its commitments. It would therefore bring about the same catastrophic economic consequences Secretary Geithner has warned against.

Wolin really seems to be saying here that Illinois has already defaulted, since it’s late on many payments it’s legally obliged to make. And that a late Social Security check is just as bad in terms of America’s creditworthiness as a missed bond payment — even if Treasury is making all of its payments to the Social Security trust fund in a timely manner.

This is a dangerous and ill-advised rhetorical tack to take. For one thing, it’s false: the transfers made from a government to its citizens are qualitatively different from its bond payments to creditors, and if they’re missed the consequences are not nearly as catastrophic. On top of that, Wolin seems to be saying that Treasury has no particular desire to differentiate its bond obligations from any other obligations. Which, at the margin, increases the likelihood of a bond default. If bonds aren’t special — if they’re just one of many US government commitments — then bondholders should rightly worry that spending cuts might hurt them, too.

There may be some political or tactical reasons why it makes sense for Treasury to talk like this. But strategically, I fear, it could turn out to be very a big mistake indeed.

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Comments
7 comments so far

You said
This is a dangerous and ill-advised rhetorical tack to take. For one thing, it’s false: the transfers made from a government to its citizens are qualitatively different from its bond payments to creditors, and if they’re missed the consequences are not nearly as catastrophic.

Very true. And actually, statements like this from the Treasury have the potential (not the certainty, mind you) of becoming self-fulfilling prophecies. This is the sort of comment that ratchets up fears of instability amongst so many already nervous, uneasy domestic and global investors. Yes, it is odd, and troubling.

Posted by EllieK | Report as abusive

The same logic was used by Dean Rusk and LBJ: “If we don’t defend South Vietnam, the world would recognize it as a failure by the U.S. to stand behind its commitments.” Whoops!

Posted by johnhhaskell | Report as abusive

This blog is about the necessity of an adjective — does “default” mean a bond default, as commonly assumed in finance, or a failure to pay any legally required obligation, as defined in the legal lexicon? Either way, a default by the U.S. Government would be troubling. Troubling for the world economy and troubling for our system of government, which would have failed to complete it’s most basic tasks.

Salmon assumes that default means a bond default. He downplays the economic effects of a default on other obligations. But Treasury has long taken the view that failure to make the payments that Congress legislates (e.g., Social Security) or that are required by contract (e.g., payments to vendors for goods and services or interest on the debt) is a default. Indeed, when I suggested last year that the Congress consider changing the priority of interest payments, I was told by the General Counsel’s office that prioritizing payments to skip some of them is the equivalent of default.

While I agree with Salmon that a default on government obligations other than bond payments would not be as catastrophic as a bond default, I believe it will still spell serious trouble for the world economy. Social Security, Medicare and military expenditures far exceed interest payments on the national debt. Delays in unemployment checks have had noticeable effects on aggregate consumption and GDP; sending IOUs instead of dollars to benefit recipients, doctors, contractors and others would have a far worse effect, especially when the recovery is still fragile.

Congress should set priorities by explicitly legislating changes in spending and revenues that reduce deficits to sustainable levels. Congress must also raise the debt ceiling, which applies to commitments already made. It should not shirk from its  responsibilities by changing the priority of interest payments and leaving Treasury to do the dirty work of figuring out which bills not to pay.

Posted by Akrueger | Report as abusive

Agreed with Akrueger, but the bond markets would surely be happier with “entitlement default” than with “bond default”, just as entitlement recipients would be happier with the latter alternative.

Which begs the question, which constituency is more important to the federal government?

Posted by TFF | Report as abusive

If Felix owes me $25 and tells me “I’ll pay you back on Friday” but doesn’t do it until the following Tuesday, is that a “default”? (And,if so, is it better if the reason is that we’re both snowed-in until Tuesday?)

By contrast, if Felix contracts to borrow $1,000 from me with the condition that he will give me $25 on the first day of February and August of every month and $1025 five years from now, I’m rather expecting those ten payments, and his missing one of them violates the terms under which I agreed to give him the money in the first place.

If he’s getting $25 in on Thursday and another $25 on Monday, it’s clear which obligation has significant consequences if it’s breached, no?

(That Tim Geithner remains an idiot, and that the policy proposed is idiotic is moot. The standard state and local government practice of moving a payment due on the last day of one fiscal year to the first day of the next does not mean the payment isn’t being made, and sowing confusion in that respect is not supposed to be part of the job description.)

Posted by klhoughton | Report as abusive

Hmmm,Tuesday accounting…”I’ll gladly pay you Tuesday for a hamburger today ” I wonder how sustainable that is.

Never fear;tweaking the books solves everything.(ask Enron)
http://www.reuters.com/article/idUSTRE70 K6OK20110121

Posted by hsvkitty | Report as abusive

Ask China about how to default on sovereign debt ($260 billion worth) and how to do so free from a default penalty:

http://www.wnd.com/?pageId=207685

Posted by Asiafinancenews | Report as abusive
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