Debt Ceiling Showdown Coming

The next political showdown over debt and deficits coming forward in the United States is over the debt ceiling. In order to keep the federal government from spending recklessly, a ceiling was placed on federal debt. Congress must vote to raise that ceiling in order to allow the government to continue to operate. In the past, this has been a perfunctory action. However, now there is a pitched battle likely to develop over the next debt ceiling vote.

Here are the issues.

• My understanding is that the legislation begins in the House of Representatives. Republican Speaker of the House John Boehner does not want brinkmanship on this issue because he fears the repercussions of a default. But he is under pressure from colleagues to make a tougher deal, just as he was in the government shutdown fight last week.
• Other House Republicans want to push this issue.  Since the Republicans control the house, the right tactical move for them is to attach spending cuts and other debt reduction measures as riders to the main bill. This way, the bill would pass the House and then be voted on in the Senate. It would be up to the Democratic-controlled Senate to approve the bill and sign it. Would they risk default to prevent the bill from passing? And if so, who would get blamed for the ensuing panic and turmoil?
• Any legislation can be passed in the Senate as a result of a simple majority 51 vote count. However, Senate rules require a 60 vote supermajority to override a filibuster.  According to the New York Times, the Republican Senate leader Mitch McConnell has appealed to Senate Republicans not to filibuster any bill that comes their way, because he, like Boehner, is afraid of the consequences of an eventual default.
• Even if a bill is not passed and the debt ceiling is breached, there are a number of things the U.S. Treasury can do to prevent a default. Experts say, that gives the Congress a window of opportunity through perhaps June or July.

A sovereign nation that issues debt in its own fiat currency cannot default involuntarily. Again, this is the Ecuador risk factor, defaulting for purely political reasons, not because of the inability to pay. It is not clear whether there will be a risk premium associated with this risk, increasing the yield of Treasury bonds, as the showdown draws near. We saw this in Russia when the Rouble crisis hit in 1998.

Russia defaulted voluntarily, an event which the geniuses at Long-Term Capital Management failed to model correctly. Moreover, the immediate stress on Russia was not the rouble-denominated debt but the mountain of foreign currency obligations via an unrealistic currency peg which were draining reserves. Similar events unfolded in Argentina a few years later as their currency board crumbled and the Peso was devalued by three-quarters.

Again, the point is that a government can always make good on its own fiat currency obligations if it chooses to do so. The real question is why a country might voluntarily default on its own currency debt

–Russia, sovereign debt defaults, and fiat currency

And in this case, it is opposition to deficit spending.  For now, the ratings agencies are relatively sanguine about this dust-up.  But, the risk of default is real – and that doesn’t sound like the hallmarks of a AAA-rated country, more like the hallmarks of a banana republic.