Odd Lots - This Is What Happens if the US Actually Hits the Debt Ceiling

Episode Date: February 16, 2023

The US is in the middle of another debt ceiling fight. The expectation is that it will get lifted before we hit the so called "drop dead" date — but what happens if Congress does not authorize more debt financing? What are the options for the government? Does this automatically lead to default? And if the US does default on its debt, what does that mean for the financial system and the real economy? On this episode of the Odd Lots podcast, we speak with George Pearkes, macro strategist at Bespoke Investment Group, about how the debt limit actually works, and we attempt to get an understanding of what to expect if we reach this uncharted territory.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon music. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Wisenthall. Joe, Debtzealing. Oh, I'm so excited. We're doing a trillion dollar coin episode. I knew. I knew you were going to say that. And I just said that to annoy you. To annoy me. Yes. This is not an episode on the trillion dollar. coin. If you are interested in that particular piece of finance thought experiment, you can check out

our previous episode on the topic. I think it was over an hour long, all about the trillion dollar coin. Yeah. Okay. Check out that episode if you want to talk about the trillion dollar coin. But today we're going to be discussing something slightly different. We are going to be talking about what exactly happens if the U.S. actually does default. Right. Because I think there's a like just a lot of uncertainty about this question of like, okay, like, what happens if they don't raise the debt ceiling? And what are the constraints? What are the various things that could happen? Like, how bad would it be if we actually like didn't pay the debt? Does the White House have ability to pay some debts but not others? Like, it's pretty uncertain. Like, it seems bad, right?

Like, it is. Laman defaulting was bad. Russia defaulting in 1998 was bad. And Russia is like this, like, It's like tiny, you know, how big was Russia debt nothing? So like, it is a moving feast of uncertainty, like a twirling whirlwind of chaos and uncertainty and open questions over exactly what happens. And there are all these moving parts. I think we really need to sit down and discuss them and kind of talk about it in an almost sequential way. Like, this is what happens.

If this happens and then that happens. So we really do have the perfect guest for this. We're going to be speaking with George Perks and Oddlots favorite, of course. He is also global macro strategist over at Bespoke Investment Group. So George, thank you so much for coming back on Oddlots. Hey, all, thanks for having me. Let's start with the basics, since we're talking about this as a sort of primer episode on the debt ceiling and the debt limit. When we talk about limits on U.S. debt, what do we mean exactly? So the U.S. is really unique in a very frustrating way. in that not only do we have restraints on spending in terms of Congress authorizing

and the president signing into law bills that create government spending and then appropriations processes after that, you know, throughout the year, we also have this break on the total amount of debt that can be issued. So Congress can at the same time instruct the government bureaucracies to go out and spend money, but at the same time say, oh, well, you can't actually issued debt to do that spending we've told you to do. And oh, by the way, you can't collect any more in taxes because we also control that. We've told you the amount you can collect in taxes. So it's this contradiction in terms of instructions to the executive branch and to various federal government bureaucracies from Congress and from the president. And it's a thing that's

been around in U.S. politics for a long time. But I think the most important thing to understand about it is that it's just nonsensical. It doesn't make sense for there to be this extra restraint on top of the existing safeguards against, you know, in a representative democracy where people are elected and then they authorize the spending on behalf of the population. We also have this thing where there's a debt, there's a debt limit that serves a sort of a secondary veto point on government spending. Defenders of the debt ceiling law would say, look, kind of, that's true, but it is good to have this debate every couple of years about our level of indebtedness. This can be used as, a break of sorts for constraining spending in the 2011 debt ceiling fight.

There really was cuts and the cuts to the growth of federal spending. You know, you're saying like, okay, like this is like the sort of like maddening law. It makes no sense. Does the debt ceiling have a history of like being used to sort of regroup and retrain our thoughts about how much we're spending? The short answer is no. I think that the more consistent way to think about it historically is that it's used by one faction or another in U.S. politics against whoever happens to sort of be the party in

control. So, you know, this is a bipartisan thing. It's used both ways. Both parties have declined to get rid of the debt ceiling on a permanent basis when they've been in power. So I don't mean to say that this is a red versus blue, you know, one side's an abuser of this versus the other. But what it does is it just creates a veto point and allows the legislative minority to extract what it wants from or some of what it wants from the legislative majority. Now, that's not necessarily the end of the world, but there are a couple things to think about here. First, the U.S. system of government is already full of veto points, right? Whether it's process of bills through committees, process of bills through the House, process of bills through the Senate, judicial checks on all

that, the executive branch, the high requirement in the Senate to sign things in the law. There are some exceptions, but basically you need a supermajority in the Senate to get things signed in the law. So there's just, we have a replete number of veto points. Adding, you know, just one more, the benefits are pretty negligible. Even if you agree that, that, you know, controlling the debt's size is a super important public policy goal, I don't happen to agree with that, but let's take that as given. Even then, there are costs associated with us that are very real. And the cost is the credibility of the U.S. his ability to pay its debts on time in full. And, you know, there are real questions about the United States Treasury's ability to settle out coupon and interest payments on debt, let alone

payments to Social Security recipients, payments to government contractors, government employees, et cetera, et cetera, this year because of this debt ceiling being present. And again, I think it's really important to emphasize debt ceiling being present, even though those payments, all those payments that are set to go out, all the spending, all the payments that are set to come into the Treasury and form of taxes, all of that has already done. been approved by Congress. The debt ceiling is a secondary approvals process that has nothing to do with keeping a lid on spending in a direct sense. So, George, you just set out the stakes kind of perfectly there. But talk to us, you also mentioned the Treasury. Talk to us about extraordinary measures because the U.S.

Treasury has already said that it started to take these extraordinary measures in order to meet its obligations because we have, in fact, already exceeded that $31.4 trillion or whatever it is, borrowing limit. What are the extraordinary measures and how do they actually play out here? So there are a variety of things that go into the extraordinary measures behind the scenes. I mean, the simplest way to think about it is changing timing of payments and sort of where there's flexibility to defer payments or to pay them, you know, without issuing debt. so wait for new payments to new tax payments to come in before sending out existing payments. That's one way to think about it.

The most important thing, though, is spending down the balance that's recorded in the Treasury General account at the Federal Reserve. So the Federal Reserve is the United States Treasury's fiscal agent, which basically means that payments are being made via the Fed. So if you're the Treasury, you don't have a checking account at a private bank. You have a checking account at the Fed. There are ways in which the government is nothing like a household, but in terms of access to a checking account, that is one way the government is like a household. There is a account at the Fed, again, called the Treasury General account, that is essentially a cash balance, a balance available for payments that is used to settle payments owed by the Treasury to other individuals or entities throughout the economy.

And what the Treasury has been able to do since 2015, whether they're able to do it beforehand, but what if they've done as a matter of course since 2015, is build up this Treasury General account in the period leading up to debt ceiling limits being reached, because that allows for flexibility over the subsequent months. Basically, if you know that you're going to be without a paycheck for a couple of months, you save some cash away in your checking account, you're not going to buy a long-term investment with it because you know you'll need it, but you'll have a little balance in your checking account and then when your paycheck doesn't come through, you can still pay your rent for a couple

months. You can't do it indefinitely, but you have this sort of cushion there. And that's sort of what the Treasury General Account spend down is. And that's the core of extraordinary measures that allows the Treasury to continue to make all the payments. It's mandated to by law, you know, whether that's payments to contractors, payments to employees, payments to beneficiaries, whatever, payments to holders of the national debt. All those can continue to go out the door as normal, in part because there's this cash balance at the TGA that's being spent down. Okay, we have these sort of like, they're called extraordinary measures, but they're not like that weird.

They're like little like cash. They're more like, you know, short-term cash management techniques that allow the government to make its obligations for a few extra months. Let's talk about like, okay, when those run out, what happens? Like where do things stand? You know, people talk, I don't know, like, what is your estimate for when like the sort of real debt limit is run when we no longer have these sort of a... The drop dead date. Yeah, the ex-date, the drop-dead date. Talk about what happens as we get

closer to that. I, so I personally don't think my estimate is any better than what we've heard from Cherry, or from Secretary of Treasury Yellen. She says June 5th is sort of her best estimate, but one, it's important to understand that she described it as having considerable uncertainty. So, for instance, if we have a really, really, really strong tax collection season or really, really week tax collection season over the next three months, that's going to have big implications for the timing here, right? Just because a huge percentage of cash flows in and out of the Treasury take place over tax season. So, you know, there's just all sorts of uncertainties. Also, private sector visibility is not great into all the timing of payments and their size. So I'll just make that

caveat. You know, I think sometime in May, June is probably the right way to think about it. Late May, early June, we'll hit this drop dead date, where essentially there are more payments being requested from the Treasury, then there is cash balance plus payments being made to the Treasury. And at that point, I think it's important to stress that we don't actually know what's going to happen. Nobody knows. There may be Treasury bureaucrats somewhere that know, but for all intents and purposes, they're not saying anything, and we can't really be sure. I think the most popular in terms of people saying, well, why don't you just do this? Option is something called prioritization, which is to make some payments and not others. So what does that look like? For instance, if the Treasury

sees that they have a payment due to... the holder of a long-term treasury bond. They will make that coupon payment, but they won't necessarily make a payment to, for instance, employees of the federal government for their paycheck. How you assign a matrix of sort of like who gets paid and who doesn't get paid in that scenario is a super fraught political question that deserves a lot of discussion. It's all hypothetical because the Treasury has said, well, we can't actually do this. We don't have the technical abilities to do this. Now, they may be bluffing when they say that. One way to sort of get a better outcome around the debt ceiling from the Treasury's perspective. Because if you're

the bureaucrats of the Treasury, what you care about is just being able to do what Congress has told you to do in terms of making payments in and out of the Treasury General account. You don't really care about the political fight. You just want to do your job. And from that perspective, Treasury has signaled quite aggressively, look, we cannot do prioritization. So if we hit the X date, then we're not going to be able to say, oh, make this payment, but not that payment. Whether that's true or whether that's sort of signaling in a game that makes default very, very costly for whoever lets it happen is an unclear thing. Like, one possible explanation is that Treasury is saying that as a way to signal to, for instance,

congressional Republicans that, hey, y'all can't do this or it's going to be really, really bad. If Treasury is being honest around prioritization, and again, I don't have any insight into, you know, I don't have a way to say, like, oh, they're not being honest, but it's definitely possible that they're sort of presenting a reality that's a little bit less the case than is other than than it really is. But assuming they're being honest, then when Treasury runs out of cash, you come to this second scenario called a general default. And that is basically saying, we're not going to make any payments to anybody because everyone's on an equal footing.

We can't tell payments apart. And we are just not going to make payments until the debt ceiling is lifted. That would be enormously disruptive and would obviously involve an outright default on certain U.S. securities. There would probably be make holes, but there would be a default. There would also be a default on everything from social security checks to government employee paychecks. The military wouldn't get paid. Military contractors wouldn't get paid. Any government contractor wouldn't get paid. Cash out of the Treasury would entirely stop. So I think in terms of the first two options around what the Treasury can do in terms of making payments, like leavers I can pull in terms of making payments, those are the two extremes. Absolute prioritization would be they have this matrix of different priorities and they make them as they're able to.

And some people don't get the payments they're owed. But Treasury is able to finally tune that to like reflect what they want to do. That's one spectrum, and the other spectrum is general default. Nobody gets anything until the ex-haling gets little bit. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. We'll bring you the latest headlines, in-depth analysis, and big interviews, all the stories that hit home on your days off. And I'm Lisa Mateo, watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world.

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It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to leading by example executives making an impact on the IHeart radio app, Apple podcast, or wherever you get your podcasts. So obviously general default of the U.S. sounds very, very bad and dire. But one of the things we've seen in previous debt ceiling dramas is that as we get closer and closer to that prospect, we tend to see market participants buying U.S. government debt as a sort of flight to safety play. So what would it mean for the actual treasury market if we got to that general default point? What would you expect to see? Well, that is where things get really fun because you have two sort of competing definitions of

fun may vary. On the Laws, definitions of fun may not apply to the non-on-Lotts universe. Okay, keep going. Exactly. So on the one hand, any missed payment on something that is assumed as just a general functioning bedrock principle of financial markets to never miss payments, whether it's principal or coupon, having a mispayment on that creates all sorts of headaches. Not only are you maybe creating for sellers of people who are not allowed to hold securities that have defaulted, and we can come back to that later. But let's assume that there's some segment of the market that says we're not allowed to hold these or we just can't be seen holding these.

So we have to sell them. On the other hand, some segment of the market would say, look, this is a political, fight. It's not a, it's not a lack of ability to pay. It's a lack of willingness to pay that's going to be temporary. So we will accept some trivial risk premium to hold these securities because at some point we trust that we're going to be made whole. You know, we might lose a little bit, but, but, you know, we're going to be paid something for holding these defaulted securities in the meantime. So we'll hold on to those. So figuring out who has these securities, who has to sell them, who wants to sell them, what prices the people who want to sell them are willing to

trade at versus the other side of the demand for these defaults securities by people with a little bit looser risk tolerance. That's going to be a really, there's going to be a lot of volatility as those securities work themselves out. There will be a series of bills around the debt ceiling maturity or around the debt ceiling X state that will be probably the most impacted relative to their historical volatility. Bills, remember, don't pay coupon payments. So, you know, your whole payment of interest comes with the maturity of the bill. So, you know, as a percentage of your total cash flow for the instrument, bills are going to be a lot more impacted. And they're also much less volatile historically. So, you know, if you see for selling, you can see sort of more outside

moves in those, in those what are typically much safer, less volatile securities. On the other hand, you've got notes, bonds, notes and bonds, which are longer term. You know, if you're thinking about a 30-year bond, one missed coupon payment that, that, you know, you probably get paid back in cash a month later, it doesn't really matter as much to the total value of security. So it's plausible that you see long-term securities that miss coupon payments during that period outperform the front end of the yield curve or fall, have their yields fall. Prices go up in absolute terms because of general risk aversion. Now, there's also a scenario here where, and we're sort of getting far out into hypotheticals without really stressing what our metrics for like this scenario are. But there's also

a scenario here where basically there isn't much change in the treasury market because the people who are willing to pay more and the people who are forced to sell or want to sell are relatively evenly matched and everything kind of just trades out at equilibrium levels. That's a very real possibility. Is it my expectation? Probably not. But it's something you have to think about. So one of the things that makes treasuries special is that they are used for collateral in the repo market. So, you know, if you're loaning or borrowing a large amount of money, you will often use treasury securities as your collateral slash security in order to do that. What would be the impact on the repo market if you had doubts over whether or not some of these

bonds are in default or are in fact going to be receiving their coupon payments on schedule? I think it's probably best to think about the repo market as an extension of the cash treasury market from that perspective and in this scenario. I think there will be some repo market makers who are willing and able to take quote-unquote defaulted treasuries as collateral and maybe apply some small haircut to them but are willing to do it for a relatively small increase in their income from the activity. You know, just like there will be people who will be willing to pay, you know, slightly less than typical for a similar security because it's defaulted, but not like,

you know, half as much, you know, that kind of thing. But we don't really know. The other thing, and I think this affects both the repo market and the cash market, is we don't really know how well the back-end settlement systems and trading systems are going to handle being able to trade something that's already past maturity, right? And hopefully there are QA and dev people at banks and at funds and at other providers who are thinking about this and have tested this. But what happens if I have to buy on, we're recording this February 9th, what happens if I have to buy on February 9th,

a bill that has a maturity date associated with it of February 7th? Can the systems even accept that or does it throw an error and say, no, you're not allowed to do that? I'm so glad you brought this up because this is something I've wondered about exactly, which is that with most financial instruments, when we're talking about default, you know, it's just like it's kind of an economic question, well, what's there, when you're going to get your recovery, etc. And I've always wondered whether like a U.S. debt default, like, would it almost be more like the Y2K problem? See, this is a crossover episode between the why companies have terrible software and, the U.S. Treasury market.

No, this is exactly what I've wondered, whether rather, whether we're thinking about it, the risks and sort of the wrong dimension, whether it's actually kind of like creates all just sort of technical things. Like, here's the one instrument that no one ever thinks about missing a payment on, etc. Right? It's like, you know, I don't know what the analogy would be. But I'm glad you brought this up because it seems like this could be the one thing. What's like, did they even, like, code the possibility that some of these instruments wouldn't

get paid and what kind of like, I mean, it's kind of speculative, right? Like it's hard to answer, but I'm glad you brought this out. Yeah, I mean, I think the team over hindsight capital would say, well, I sure hope they've been coding this because, you know, we've known it's a possibility. Yeah. When are we going to get the CIA? They just kill it. Every single trade, they're way ahead of things. But yeah, I mean, we've known this as at least a hypothetical possibility since at least 2011. So you would hope, right, that there's been some efforts to make sure that settlement systems can handle this sort of thing. But just because you would hope that doesn't mean, you can actually say like, oh, yeah, that's how it would work. I know at some level, there would be

settlement of treasury securities that had defaulted. I mean, you can do stuff over the phone. You can do stuff with manual settlement procedures. But there's just no way that the market's can be able to handle super high volumes if everyone's normal trading systems are just not working correctly because of, for instance, a maturity date that's prior to a settlement date, right? Like, it's just, I think there would probably be some disruptions there. So, you know, that adds a liquidity dimension and, you know, liquidity being withdrawn possibly due to, due to issues in the software on top of the absolute risk premiums that people are willing to bear.

And, you know, this all applies equally to repo too, you know, with repo instead of thinking, like, oh, I want to buy or sell bond, it's like, oh, if I want to use this bond as collateral in my system accepted as collateral if it's got a date that's later, you know, same principles, basically. So, yeah, I mean, I don't know the answer to any of this, to be clear. Like, I used to work relatively close to bank settlement systems back at my prior role, but I haven't been near a bank settlement systems in almost a decade now. So, you know, I don't know. And I'm not sure anyone anywhere knows with great certainty what the aggregate trading community, whether it's fast money, real money, you know, what they can handle in this respect. But, um, yeah, I don't know.

So I want to talk about another, you know, go back to this idea or talk about this idea of, you hear payment prioritization. And of course, as you mentioned, Treasury has insisted, maybe they're bluffing that it's technically, they don't have the capability to say, shut off one kind of payments easily while, say, like, making sure that we continue to pay or debt. But setting aside the technical questions of whether they can do that. What about like the political questions of who gets to decide what shuts down? Because if you're Biden, it's like, okay, like, we're not going to pay the military. And look, the Republicans are preventing the military, are brave men and women from getting paid. Look, and then the Republicans

might say, well, you didn't have to shut down military payment, et cetera. You could have like done something less impactful, et cetera. But who gets to decide even a prioritization what does and doesn't get paid? Yeah. Totally. There are deep. political questions about every facet of this whole problem. And I think it does illustrate so well how debt is a fundamentally political thing. I mean, we have our constitution because the first crack post-revolution at creating a structure for governance in the U.S. didn't handle debt well. Like, that's literally why we have the constitution we have today. Obviously, there's more stuff in the constitution than just management of debt. But there is a general problem here where you are taking

what was the purview of Congress and elected representatives in assigning payments to various stakeholders that the Treasury faces on a settlement basis. And you're taking that away and you're handing it to Treasury with no explicit decision to do so. If you're going to prioritize without legislation, and there will be no legislation on this, you know, then Treasury, unelected bureaucrats at Treasury are just being told to make the best of it that they can and have fun figuring it out. that is not how a government's supposed to be run, right? I mean, that's not how a democracy is supposed to function. If Congress had wanted to delegate prioritization to Treasury and said that explicitly, that would be a fine, whatever, that's their purview. But that's not what's going on here. It's Congress saying, well, we're not going to do anything, so just do the best you can and throwing it back to Treasury.

And when you get that outcome, I mean, that's not going to be good for anybody, regardless of who the winners and losers' treasury picks are, if they even have the ability to make those picks. it's a pretty deep irony that a representative democratic system is doing this to itself. And again, I just, I want to emphasize that this is Congress doing it to itself. This is not, this is, this is not an inherent thing around national debt management. This is a series of bad decisions that have been made by elected representatives over the past 30, 40 years that have gotten us to this point. And it's entirely a self-inflicted situation. I think this is such an important point to make this idea that debt is ultimately a social construct and inherently political in many ways. You know, it tells a story of who owes who, what, and why. And so it's immediately caught up

in, you know, the potential for different narratives. You mentioned how self-defeating a lot of this tends to be in the U.S. And it does seem, to put it mildly, that defaulting on U.S. debt would be bad. So what would happen if, you know, the executive branch just decided to ignore Congress on this? Like, what if people just go off and, you know, the president goes off and does his own thing? So earlier we were talking about, I mentioned how fun it would be if we had a general default and what that would mean for the treasury market. As for the treasury market functioning fund, same thing for constitutional fun in this instance that you just described. So just as a bit of background, if you read Section 4 of the 14th Amendment, one of the key reconstruction amendments, after the Civil War, there's a clause that says the validity of the public debt of the United States

authorized by law, including debts incurred for payment of pensions and bounties for services and suppressing insurrection or rebellion, shall not be questioned. So this is just basically saying, like, there's a general constitutional principle that if the United States government owes someone something, you can't get in the way of that, right? Like, that's the plain text reading of that. How far do those powers go? It's an interesting question. No one's ever really litigated it. This clause section four was mentioned in a litigation around a New Deal case, but it wasn't, it wasn't really directly established to be read in a maximalist or minimalist way. Other parts of the 14th Amendment have been litigated to the end of time. I mean, there's one of the most litigated parts of the entire Constitution that the Supreme Court hears cases on. But this particular section has very little litigation associated with it. So we don't really know what courts would do.

But if you read that text, just as sort of a plain text, then it seems to create a constitutional obligation to pay the public debt of the United States. And it's one thing to say, well, you know, we can't pay the public debt because we've run out of dollars. But we know you and I, Joe and Tracy, and hopefully Audlots listeners at this point know that the Treasury creates dollars and the Federal Reserve creates dollars. And there's no lack of those dollars. You know, can't run out of them. So that's not a restraint. what then is preventing the federal government, or specifically the executive branch and the treasury, from going out and doing what the Constitution tells it to do by preventing people from questioning the debt and just saying restraints on issuance of debt to make good on payments owed by the United States to third parties are unconstitutional. The debt ceiling is unconstitutional, and we're going to keep issuing debt to make payments until someone tells us to stop. That path, is one that is hard to see from a political group that has been as risk-averse as the Biden administration

has been. But I do think you can make a very good case that in an emergency, a situation where there's a general default, where, you know, markets are crashing, where, you know, there's massive economic disruption, that this is a good choice to be made. That the debt ceiling is totally self-defeating. It's a, it shouldn't exist in the first place. And by the way, There's a constitutional reading right here. Now, I'm not a constitutional scholar. I'm not a constitutional lawyer. I'm none of those things.

Like Jay-Z said, I pass the bar, but I know a little bit. I know enough to know that this could hypothetically work, but that's about it. So I don't think I would predict that the Biden administration should or could go out and do this. But it is interesting to think about how these powers appear to be given to them by the Constitution and that there could be a Supreme Court case settled based on whether the U.S. has just issued bonds that are illegal under the Constitution. You know, again, fun. So, okay, we're not going to have like a coin conversation, but this does get to the other possibility,

which is these technical workarounds that people believe exist in the law. So one possibility, one of these workarounds could be invoked the 14th Amendment. And it seems pretty clear. The history on that does not seem to be particularly ambiguous about why it's there. And it's kind of, you know, I'm reading on Congress.gov, inspired by the desire to put beyond question the obligations for the government issued during the Civil War. And so, like, I don't know, like it doesn't seem particularly ambiguous. But setting aside the 14th, talk to us about some of these other ideas in the law to avoid a default. I think the easiest one to understand, and easy by the, you know, if you know a little bit of bond math, the easiest one to understand is this idea of issuing very high coupon bonds.

So when we issue a bond, typically what happens is there's a bullet bond is a standard term for what people think of as, you know, for instance, a treasury bond where you get a series of payments over time that are called coupons, that are regular small payments, and then you get a big payment at the end, which is called the principal, right? principle is, you know, typically you pay, you quote the price of a bond as the percentage of the principal payment that you will receive at the end. So, for instance, if a bond is trading at 95, that means you pay $95 now, and then you get the series of coupon payments associated with that bond and the principal payment at the end, which is 100. When Treasury auction securities, they are sensitive to, they basically want to set the price of those securities just below 100 when they're first issued. They don't want to issue. They don't want to issue. bonds at a premium, and they also have a series of other constraints, like, for instance,

the minimum increment of coupon. So what they'll do is they'll issue bonds with a coupon that sets the principal payment, or, sorry, sets the auction price just below 100 when they issue. So, for instance, they're not going to go out and issue a 15-coupon, 15% coupon bond when the prevailing yield on Treasury securities is like 5%, right? Like, they're never going to do that. But that's just like an internal norm. That's not like written in law anywhere. They don't have a legal obligation to do it that way. If they wanted to, they could go out and issue a bond that matures with a principal value of 100 and pays coupon payments of 100, 100 percent per year for the next 30 years, say. So let's say, for instance, they did this. They said, we're going to issue what's

called a super high coupon bond. And again, this is nonsense territory from a pure finance perspective. But But let's say they go out and that bond that matures 30 years from now at a phase 5 of 100, it'll pay 100 in coupons every year as opposed to the, you know, 4% coupon on the most recent relationship with 30-year bond, something like that. So if you do the bond math on that, if you discount all those cash flows back to present value at the current prevailing interest rate, what you've got is an $1,800. You receive $1,800 today for the bond maturing at 100 in the future. And the reason you get that is because it's got that long string of payments associated

with it with the same size as the as the principal payment. You've basically issued a zero coupon strip all in one instrument for the next 30 years. And you've done that. The impact to the debt ceiling is 100, but you now have another 1,700 in your pocket because of those coupon payments. Those coupon payments aren't covered by the debt ceiling. They're coupon payments, not principal payments, right? When Treasury counts debt, they're not counting the interest cost. They're counting the principal value. So that $100 is, I mean, like it's a technicality where you can say, well, the coupon isn't principal, but it's still cash in my pocket now delivered at a later date that doesn't count against the debt ceiling.

So, you know, that would be another technical workaround they could use. Again, this one is on much less dicey legal footing. There are lots of reasons why Treasury would maybe want to say we don't want to do this. We don't have any interest in this. We're not able to do this, whatever. there could be lots of reasons for that. But legally, it's not quite as dicey as saying to Congress in the Supreme Court, well, we're just going to keep issuing debt and, you know, take your best shot at stopping us.

I'm trying to think what would be a harder sell to the public. Is it, you know, issuing a high coupon bond that, like, gets you immediate proceeds that are a lot more than the actual issuance amount, or is it a large novelty coin? Well, I mean, so I was going to, you know, the novelty coin, I'm sure, you know, we know the headlines are going to be around that. But, you know, at the same time, I'm imagining Biden is borrowing at 100% interest rates from China to like the payday loan to like, you know, like the headlines could go in either direction. Yeah, for sure. Yeah, I mean, but then you have to explain like, like, what, how it's even possible to borrow at 100% interest rates or, or like, what is even

happening there. I mean, I do think both the coin for all its downsides, Tracy, I know how much you You love the coin, but, you know, the benefit of both the high coupon bond plan and the coin plan is that they're weird incantations, you know, run by technocrats. They're not, they're not like a tangible thing where it's like the U.S. Constitution and like this sort of feeling that the world is going astray. It's like, oh, well, they said the right words and everything's fixed now. So who cares? Is how people tend to think about this stuff, I think? Whereas when you were talking about the Supreme Court and the Constitution and Article Section 4 of the 14th Amendment and the history and that people get very open arms, oh, the Constitution, you know, whatever.

Whereas if it's just like, oh, we just said the right words magically to the bottom market, and now everything's fine. I think you get a very different, you know, feeling from that politically. But that's speculation on my part. This is something. There's important, which is that, okay, let's say the administration say, you know what, the 14th Amendment says the debt ceiling is invalid. We're just going to ignore it and continue fiscal operations as normal. And then as you pointed out, there might be some ambiguity about whether the bonds issued after that moment are legal, and maybe it would get to the Supreme Court, and we don't really know what they would be going to say. But to some extent, this even applies to any other solution as well, including the high coupon bonds,

including the coin, which is that like someone could sue over the coin. Like, no one's going to stop it. And if like five out of the nine Supreme Court justices says, like you can't issue a hundred year bonds, like that's clearly in violation of the spirit of the debt sailing law, you know, you're still issuing debt at a time where you're not supposed to issue any more debt. Like the uncertainty exists in almost any of these scenarios. For sure. And, you know, we said it before and I'll say it again, this is all a political question, a social question, right?

Like political power means telling people to do something that they don't want to do. That is what political power is, right? And whether it's the Biden administration forcing issuance of new debt, whether it's the Supreme Court stepping in to either validate that or, or, or invalidate that, you know, that's the 14th Amendment scenario, or whether it's the Biden administration is saying, okay, we're not going to make any payments regardless of who doesn't get paid, or it's prioritization where some people get paid, for instance, bondholders maybe get paid, but, you know, retirees don't. Like, whatever approach you take to this, at some point, someone is being told

you don't get what you want because you can't stop me, you know, under our system, right? Like, you physically can't stop me or you, you know, enough of other political bodies have sided with me so that you can't get done what's what you want to get done. And, you know, this is a like at the end of the day, the debt ceiling has lots of interesting financial and economic and analytical things to explore. But it's always going to come back to being a political problem. It was created by politicians. It's being exacerbated by politicians. And it will be solved through political means and nothing else. And, you know, I just, I always come back to that.

I really, from that perspective, I cannot emphasize enough that Congress has created this problem for itself. And if there was justice, then Congress would lose power in some sense over this, whether it's the debt ceiling is invalidated by the Supreme Court or by the Biden administration or whatever or, you know, some other solution. Unfortunately, like the world doesn't work based on carmic justice. So I don't think we can hope that, oh, well, Congress gets its comeuppance. But maybe they will. I mean, we'll see. I mean, it's going to be an interesting few months here to say the least. This is Tom Keene, inviting you to join us for the Bloomberg Surveillance Podcast. It's about making you smarter every business day.

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executives making an impact on the, I heart radio app, Apple Podcast, or wherever you get your podcasts. So the overarching theme of this conversation is just mass uncertainty, lots of hypotheticals shooting out in every different direction. And no one really knows what's going to happen when we finally hit that X date, the drop dead date. But there is something sort of more immediate, a potential more immediate impact. And I think we touched on this when we were talking about TGA balances, this idea of, you know, the treasuries check. account at the Fed, it does have an impact on liquidity. So what's going on with the TGA,

you know, if there's more money in there, if there's less money in there, it can mean different levels of liquidity for the broader economic system, for companies that might be due payments from the government. Talk to us a little bit about the immediate impact of all this discussion over the debt ceiling on market liquidity and monetary policy as well. Yeah. So this is kind of of a perverse thing about how the mechanics of the TGA being inflated with that sort of cushion we discussed earlier. It's perverse how this works because when the Treasury is building up that cushion, they are withdrawing aggregate liquidity from the private sector. Treasury is withdrawing liquidity from the private sector because that increase in TGA balances is being

funded by some combination of higher debt and higher taxes relative to spending. It's debt, right? the Treasury's issuing more bills and more notes and bonds than they technically need for the specific period in time. That means cash balances are being dragged out of the private sector and to the Treasury's cash balance at the Fed. That's a Federal Reserve liability, just like a Fed fund is, but the liability that the Fed holds in the TGA, the only asset, the only person who can hold that as an asset is Treasury. Whereas Federal Reserve, Fed funds are an asset that can be held by the banking sector and use to match against deposits that are an asset of the rest of the private sector. So basically, it's like reverse QE, right, when this TGA is being built up. It's pulling

liquidity out of the private sector and storing it in the TGA. Then as the TGA is released, it does the opposite, right? So it unleashes private sector liquidity because that liability of the federal, of the Federal Reserve to the Treasury is being spent down. The payments are winding up as assets of the rest of the private sector or the rest of the world, basically everybody but the federal government funded by Federal Reserve Fed funds, liabilities of the Fed. So it's basically a countercyclical thing, right? Like it's as times are good and we're going along, the TGA gets built up and then, oh, we've got worries about that ceiling, but at the same time, a bunch of liquidity is being unleashed. Now, the sizes here are not necessarily huge. It sort of depends on the

specific instance. But the size of the TGA has gotten pretty big, relatively to the rest of the Fed's balance sheet as a matter of course since 2015. So prior to the global financial crisis, 2007 to 2008 kind of range, the TGA was less than 1% of the Fed's balance sheet. Basically, payments and payments out almost precisely matched each other day to day. From 2008 to 2015, it built up a little bit because just the scope of federal government spending went up. There was a lot more issuance of debt with post-crisis deficits that were that slowly sort

of declined from the peaks in 2009. But then when we get to 2015 and Treasury says, okay, well, we want to start building up this cash balance. From 2015 to 2020, it averaged 6% of the Fed's balance sheet. So it was below 1% before the global financial crisis. Immediate after is about 2%. After that, after 2015, 6%. Since Q1 of 2020, it's been 11% of the Fed's balance sheet. That's a huge percentage of the Fed's balance sheet. And it swings around quite a lot, unlike, for instance, the QE asset purchase portfolio. So basically, you've got this complicating factor that has nothing to do with the Fed's monetary policy setting. The Fed's, the Fed is not

changing policy based on Treasury cash management. And yet, it's got this sort of impact on aggregate private sector liquidity, both positive and negative, depending on what's going on with the TGA, that you have to account for. So, you know, as we see the TGA spend down over the next few months, it's already underway, that will have an impact on aggregate private sector liquidity that will be kind of sort of counterintuitive, I guess you could say. Right now, there's about $560 billion in the Treasury General account. That's down from a peak of almost a trillion in May of last year, the recent peak. It's sort of trended lower over the past seven months or so. And that'll continue to trend lower as we go from $560 down to zero, presumably, or near zero at the X state.

All right. I want to ask one more markets related question. And I think there's this fantasy that people have, which is that the stock market becomes this sort of forcing mechanism. The example that everyone would cite is the TARP vote. It failed in 2008, then the stock market crashed some more, and then they passed it a couple days later. It doesn't seem like that dynamic really holds with the dead ceiling, because even though there's this potential for catastrophe or uncertainty, the view among stocks investors seems to be they always get it done in the end. Why would I sell my stock, et cetera? Like, can you talk a little bit about like, As we get closer, is there any sort of like history or like the sort of interplay between

market volatility and pressure to just like, all right, let's get it passed? There is no doubt that there is a feedback loop between asset markets and how politicians think in this country. I mean, using a more recent example from then the TARP vote, which I think is a good, good one, you could look to what happened in the spring of 2020, right? We saw a degree of fiscal stimulus and a degree of support for households that completely unprecedented in American history and completely, like, if you had dreamed up with a scenario where that happens, even if you had, you know, known about COVID coming and you had said, okay, well, then you're going to see this public sector response to that. I don't think anyone would have believed you. You'd have just said, no, there's no way that the Republican Congress will do that. There's no way that Republicans and Congress will okay that. There's no way that I'll get through filibusters and all that. And it absolutely did. And it did so immediately because asset markets were in free fall, right? there is a lot more feedback to political economy in this country and to political outcomes in this country from the stock market than from the unemployment rate. That is just how things work.

I'm not defending that. It's just the reality. So I do think that if we see stock markets start to fall, you know, measurably, you know, like big volatility, big downside in the months or weeks leading up to the sort of X state as it sort of becomes more clear, then you will definitely seem a lot of pressure on politicians to just raise the dang thing, you know, have your fights about something else. Whether that comes from people within the respective ideological circles of each party, whether that comes from the public as a whole, it's unclear. But either way, there will be significant pressure. If, however, stock markets say, well, you know, like, they'll figure it out and maybe there'll be a default, but, like, they'll pay those back eventually and

people will be calm and say it. And, like, there'll be plenty of people that are willing to pick up an extra 25 basis points in a Treasury bill to hold it for a few months while they figure all this out and it'll be fine. And so we can just sort of look past that. If that happens, that's a recipe for a much more protracted fight and a much longer time past the X date with, you know, uncertainty going on. Now, my view would be that if you get to the X state, even if you have prioritization, barring using one of the technical workarounds we discussed, so either the coin or using high coupon bonds or just saying, well, this violates the 14th Amendment, so we're going to ignore the debt ceiling. If you don't have those and you have either prioritization,

which Treasury said is impossible, but could be possible, and you're working through prioritization, or if you're just doing a general default, where we're not paying any payments until the debt ceiling's raised, because that's what the law tells us to do if I'm the Treasury. Okay, either way, in either a prior to a severe prioritization scenario or a general default, you're going to have large economic impacts from that, right? Like the volume of outgoing payments that are not going to show up in the bank accounts of people that want to spend them, whether those are businesses, whether they're individuals, is going to be really big. Social Security is a really good example.

If you stop paying Social Security, the entire economy grants to a halt about a month. It's just such a huge cash flow for such a large percentage of population that you can't. So eventually there will be a feedback to asset markets. This will not last forever where it's just kind of the new normal that the U.S. permanently has the destiny in place and only making some outgoing payments. Eventually, the economy starts to collapse. the stock market starts to collapse and you know you see. And another interesting thing, just to work it back to the Fed, an interesting thing to think about it is if the economy is collapsing

because all these payments aren't going out and the stock market is in freefall, does the Fed step in to say, okay, well, we're going to cut rates now because the economy is in freefall because of what's going on with the death ceiling? Or do they say, not our problem? I don't know. I don't have a good answer for that. I don't think a good answer exists, but it's something interesting to think about. It feels like this is one of those topics where there just aren't a lot of good answers. But George did a good job. Yeah, you did a great job. There's a lot of uncertainty in hypotheticals. As we've been talking about, it's not an easy thing to sort of lay out all the different options and what might happen depending on what's pursued. But George, it was great

having you on. You did a great job. Thank you so much. Yeah, thanks for having me on. I mean, I can stick around for another three hours and we can really get all the different hypotheticals if you want. All right. Now, hour two, the coin conversation. Okay, I'm leaving. Bam, let's go. Thanks for having me on you. Take care of George. Thanks, George.

Joe, there's a lot to unpack from that conversation. I agree, but George did like a great job sort of like, you know, there is a lot of uncertainty. I guess because it's something that had been lodged in my mind. But like I'm glad he brought up that question of like the software element of settling defaulted debt. Because it's just something like I want, like people like, you know, like we don't talk about debt in those terms. It seems totally like a Y2. K type thing, as you mentioned, where people just would not expect U.S. Treasuries to default. And anyway, why would you prepare for such a scenario? Because if that were to happen,

then it would be the collapse of the financial system as we know it. But yet, here we are, you know, after 2011, after 2013, having a very similar conversation. The other thing that stuck out in my mind was George's point about, you know, ultimately this is a political process. And it plays out in debt. But the reason it plays out in the debt market. market is because debt is inherently, I think, so tied up with questions of morality and justice. And it's so easy to build a political narrative on top of something that is ultimately about who owes what to who and why. Absolutely. And, you know, I think that's why it's really notable that this was written into the Constitution and was written into the Constitution after the Civil

War. And when we did have that coin conversation, who was with Rowan Gray in 2021, he talked about this as well, which is that like this fear that in the pursuit of the civil war, that Southern representatives from the formerly Confederate state would try to induce a default because it's like, oh, we don't want to pay the debts of the northern government that fought a war against us. And so they did like, this is like, you know, it gets to like deep constitutional questions and it continues to play out over and over again in different forms. The political weaponization of debt. It seems to be happening more often because I think people have realized that it is an effective pressure point, as George laid out. Well, on that happy note, shall we leave it there?

Let's leave it there. Okay. This has been another episode of the Odd Lots podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wisenthal. You can follow me on Twitter at The Starwort. George doesn't really tweet anymore, but maybe he'll come back one day, so I'll plug it anyway. His handle is at Perks. Follow our producer, Carmen Rodriguez, at Carmen Armin, and Dash Bennett at DashBot. And check out all of our podcasts at Bloomberg under the handle at podcasts. And for more Odd Lots content, go to Bloomberg.com slash Oddlots. When we post the transcripts, we have a blog and a weekly newsletter that goes out every Friday.

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