News in Charts: The US debt debate: platinum, coins and ceilings

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Last week’s News in Charts discussed the compromise agreement to delay most of the spending cuts and tax hikes that have become known as the fiscal cliff. In this week’s edition, we review the next steps. In particular, we focus on upcoming negotiations over the statutory debt limit, which will need to be raised soon. In the end, we expect developments to play out in similar style to those seen during the fiscal cliff negotiations. In other words, we expect a last minute deal that does not resolve the underlying problem, but at least avoids short-term catastrophe. Nevertheless, there is the risk of significant market volatility, especially if negotiations are particularly combative or protracted.

As the chart below indicates, the debt ceiling has never been anything more than a symbolic measure, rising in-line with federal borrowing. In recent years, however, the issue of raising the debt ceiling has become something of a political football, as officials have tried to use the threat of not raising the debt ceiling, and implicitly US default, to achieve political objectives. The recently re-elected Republican Speaker of the House, John Boehner, has said that he will only back an increase in the debt ceiling if it is matched by offsetting spending cuts spread over ten years. The White House spokesman has responded by saying that ‘there is no alternative to Congress raising the debt ceiling…President Obama won’t negotiate with Congress over raising the nation’s borrowing limit’.

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We have been here before. In the summer of 2011, Boehner and President Obama faced off in tense negotiations to increase the nation’s borrowing limit. A deal was eventually reached, but not without significant instability in financial markets. In the month leading up to the agreement, the benchmark S&P 500 fell by close to 20%. Some of this no doubt reflected investor worries over the situation in Europe, but dithering by US politicians also had a role to play. The negative impact wasn’t only temporary. Just days after a compromise deal was announced, S&P downgraded its credit rating on US sovereign debt. In its report the ratings agency cited the weakened ‘effectiveness, stability, and predictability of American policymaking’.

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Given the dire outcome witnessed at the last go-round, it is unlikely that politicians will flirt as closely with avoiding a debt ceiling increase. But a less benign scenario cannot be ruled out completely. Already, pundits and market participants have been looking at what the Treasury could do if a downside scenario plays out and it runs out of cash in late February or early March. Prominent among the suggestions is an idea to mint a platinum $1trn coin, while an alternative to simply ignore the debt ceiling, using the 14th amendment as cover, has also been mooted.

Under the platinum coin scenario, the Treasury would mint a $1trn platinum coin and deposit it with the Fed in exchange for funds. It could then use this money to pay its bills as it sees fit. Currently, the Fed has assets in coin worth just over $2bn. It is unclear whether it would sell some of its other assets in order to offset implied increase in its balance sheet. Eventually, once the debt ceiling is raised, the Treasury would be expected to issue bonds to pay back the $1trn, and the coin could be melted. While unusual, this route has gained the legal backing of experts. This suggests that the debt ceiling is effectively non-binding. The Treasury can chose to bypass it if it wishes.

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A more controversial solution involves the Treasury ignoring the debt ceiling and issuing fresh bonds on the basis of the 14th amendment pledge that the validity of US public debt ‘shall not be questioned’. Legally, this idea appears to be on shakier grounds and would almost certainly be met by substantial political backlash and challenged in the courts. The platinum coin, while in many ways ridiculous, appears to be the more sensible solution.

On balance, we attach very little weight to a scenario in which politicians refuse to raise the debt ceiling. Investors appear to agree. While the cost of insuring against a default by the US government has risen slightly in recent days, it remains at an extremely low level. At just over 40bps, its price is broadly in line with its average since the recovery began in June 2009. This suggests that investors in Treasuries remain relaxed about the prospect of a hard US default.

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While we expect that politicians will eventually reach a deal, their dithering should not be seen as costless. By fuelling uncertainty in recent years, fiscal policymakers have reduced household and business confidence, in turn hindering the economic recovery. By contrast, the Fed has been bold and pro-active since the financial crisis began. Monetary policymakers were quick to respond and have continued to provide stimulus as the recovery has disappointed. These actions have helped to prevent the Great Recession from turning into a Great Depression. Leaders on the Hill are advised to take notice.

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