At some point after Oct. 17, the U.S. government won't have enough money to pay all its bills. And, if Congress fails to raise the debt ceiling, which still is a real possibility, the government won't be able to borrow more to meet those obligations.
That creates the risk that the United States could default on its debt — if, say, there's not enough cash on hand to pay bondholders when interest payments come due.
Both the Treasury Department and financial analysts agree this could lead to Armageddon. Large swaths of the global financial system are structured around the idea that U.S. debt is the safest in the world. If that assumption was ever called into question, chaos would ensue.
Some Republicans, however, are now downplaying this possibility: If the United States does breach its debt ceiling, they'll note, why can't President Obama just pick and choose which bills to pay? Surely he could just keep paying bondholders in order to avert a financial calamity while delaying payments for everyone else, right?
"There's always revenue coming into the Treasury, certainly enough revenue to pay interest," Rep. Justin Amash (R-Mich) told National Journal.
But there are a few big problems with this "prioritization" plan: For one, it could prove extremely difficult for the Treasury Department to prioritize payments in this way and avoid default. This is murky terrain, both logistically and legally. Second, even if the Obama administration could put bondholders first, breaching the debt ceiling would still cause massive disruptions elsewhere in the U.S. economy.
How the U.S. government normally makes payments
When everything is running smoothly, the Treasury Department typically receives around two million invoices a day from various agencies. The Department of Defense might send a notice that it owes a contractor $1 million for work on a weapons system. Treasury's computers make sure the figures are correct and then authorize the payment. This is all done automatically, dozens of times per second.
These payments all flow through the recently-formed Office of Fiscal Service. And there appear to be two broad systems here:
Again, that's how things work normally. Money comes in, money goes out, automatically, millions of times each day. The question is what happens if the United States breaches the debt ceiling and sufficient funds stop coming in because the government can't keep borrowing...
The Treasury view: Prioritization isn't possible!
The Treasury Department maintains that it has no ability to pick and choose which bills to pay if it's short of cash. According to the agency's inspector general, its computer systems are designed to "make each payment in the order it comes due." Full stop.
Under this view, if Congress fails to lift the debt ceiling, the U.S. government will only have money to cover about 65 percent of its bills. Some payments will simply fail to clear. Perhaps a payment to a defense contractor comes up short. Maybe a Social Security check bounces. Maybe an interest payment to bondholders fails.
That last possibility is the most worrisome. If the U.S. government misses a payment to bondholders, the consequences could be severe. "A default would be unprecedented and has the potential to be catastrophic," warns Treasury. "Credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse."
Other financial analysts agree. A missed debt payment could cause the entire financial system to seize up. "Let us be perfectly clear," warns a note from RBC Capital Markets, "crossing the debt ceiling would be catastrophic."
The argument for prioritization
That's why some market analysts — and many Republicans — think there's no way the U.S. government would ever allow a debt default. Surely the Treasury Department will do everything in its power to avoid the apocalypse. That means paying bondholders first and delaying payments to everyone else if necessary.
A recent note from analysts at Credit Suisse (via Cardiff Garcia), for instance, argues that "if push comes to shove and Congress cannot strike a deal in time, the ability to pick and choose who gets paid does exist, if only on a broad basis."
One possible way this might work is that the Bureau of the Public Debt would keep making payments to bondholders through Fedwire, and Treasury would halt the computer systems that make payments to other government agencies and vendors. ("The way that [these systems] are set up, they can either be set to 'on' or 'off' – i.e., a system either makes all of its payments or it doesn’t make any at all," notes Credit Suisse.)
The problems with prioritization
But prioritization is hardly a sure thing. There are two major hitches here:
1) It might not be legal. It's unclear whether Treasury even has the legal authority to prioritize payments — the agency has never dealt with this situation before. "Anyone who says they know for sure whether this is legal is not telling the truth," said Steve Bell, a former Republican staff director of the Senate Budget Committee now at the Bipartisan Policy Center.
The key question is whether the Treasury Department could stop paying people on certain days in order "save up" money for debt service — say, for the $31 billion in interest payments that will come due on Nov. 15. And there's simply no clear law here. (See pages 8 and 9 of this Congressional Research Service report for more detail.)
Those legal questions could, in theory, be cleared up: Back in 2011, Sen. Pat Toomey (R-Penn.) introduced a bill that would require Treasury to prioritize bondholders above everyone else. But that bill never passed Congress.
2) It might fail, logistically. Again, the Treasury Department has long insisted that its payment systems simply aren't set up for prioritization.
Here's Mark Patterson, a former chief of staff at Treasury: "The U.S. government’s payment system is sprawling," he explained. "It involves multiple agencies. It involves multiple interacting computer systems. And all of them are designed for only one thing: To pay all bills on time. The technological challenge of trying to adapt that to some other system would be very daunting, and I suspect that if we were forced into a mode like that the results would be riddled with all kinds of errors."
Now, it's possible that the Treasury Department is bluffing in order to put pressure on Congress. It's possible that they're secretly at work on a plan to avoid a debt default in the event of a financial meltdown. It's possible that, as Dan Mitchell of the Cato Institute says, "Treasury Department has plenty of competent people who would somehow figure out how to prioritize payments.”
But that's placing a fair bit of faith in government tech (more than the libertarian Cato Institute typically does): Note that the U.S. government is still struggling to set up a glitch-free Web site for Obamacare's federal exchanges. Similar glitches in any scheme to prioritize payments would have more serious consequences.
How serious? Back in 1979, after Congress dithered on a debt-ceiling increase, the government inadvertently defaulted on about $122 million worth of Treasury bills, due to unexpectedly high demand and an error in word-processing equipment. This was only temporary, and Treasury quickly corrected the error.
Still, the damage was long-lasting. A 1989 study in the Financial Review estimated that the incident raised the nation's borrowing costs by about 0.6 percent, or $12 billion. And the damage lasted for months. That was after a brief, accidental default that was quickly fixed. A breach today would be an intentional action that would speak to serious changes — and new risks — in the American political system.
Even if the government could prioritize bondholders, a debt-ceiling breach could still inflict plenty of economic harm.
Okay, now let's imagine the Treasury Department somehow figured out how to revamp its systems to prioritize bondholders. And they skirted all the legal questions.
Even in this scenario, a debt-ceiling breach could still cause economic havoc. Remember, once we blow past the debt ceiling, the U.S. government will only bring in enough revenue to cover about 65 percent of its expenses. The government would have to cut back on something else, whether it's Social Security or Medicare or veterans benefits or any of the millions of other payments it approves each day. More than $100 billion would get sucked out of the economy over the coming month.
Sam Ro points to a research note by Goldman Sachs on the dire consequences:
If the Treasury decided to set aside interest payments and make other payments in arrears, we estimate it would result in a pullback in primary (i.e., noninterest) outlays of 4.2% of GDP (annualized). In both cases, the effect on quarterly growth rates (rather than levels) could be even greater.
If this were allowed to occur, it could lead to a rapid downturn in economic activity if not reversed very quickly.
So it's possible, though not certain, that the Obama administration could avert a default and complete meltdown of financial markets in the event of a debt-ceiling breach. But avoiding a recession would be extremely difficult.
And markets would likely react badly in either case: A recent note from Deutsche Bank's David Bianco estimates that if we blow past the debt ceiling and Treasury starts prioritizing payments, the S&P 500 could lose 10 percent of its value (see the orange line). And that's without an actual default on the debt:
That helps explain why administration officials are dead set against prioritization: "Any plan to prioritize some payments over others is simply default by another name," wrote Treasury Secretary Jack Lew in a letter to Congress. "There is no way of knowing the damage any prioritization plan would have on our economy and financial markets."
--Cardiff Garcia has an excellent post on prioritization, noting that the Treasury Department has kept many of key details hidden. "And yes, obviously Jack Lew has to be evasive about the possibility. ... To acknowledge that payment prioritisation is possible would enable the Republicans to force the president to use it. "