FROM THE OFFICE OF PUBLIC AFFAIRS

Finding a Better Way

A wise man once said, “The great enemy of the truth is very often not the lie – deliberate, contrived, and dishonest – but the myth – persistent, persuasive, and unrealistic”.

In my brief time in Washington, I’ve found the worst myth to be the belief that the debt ceiling imposes any control on government spending. The plain truth is that the debt limit does not affect the deficits or surpluses; the critical revenue and spending decisions are made during the congressional budget process.

The “debt limit” myth bears special attention today because in spite of a recent increase in the debt limit, mythically characterized by some as “the largest increase ever”- not true - this issue will confront the Congress, the Treasury and the fixed income market yet again in the not too distant future. It is imprudent and unwise to risk the United State’s privileged standing in the capital markets with this all too frequent self imposed political imbroglio. The challenge and necessity before us is clear: we must maintain Congress’s constitutional granted authority for borrowing on “the full faith and credit of the U.S.” but better align it with the practical necessity of the Treasury’s responsibility to finance the gap between congressionally approved changes to revenues and expenditures. An active financial market community voice must not be mute in urging a solution to this problem.

Definition & history

The authority to borrow on the full faith and credit of the United States is vested in Congress by the Constitution: Article I, Section 8, and Clause 2 –“The Congress shall have power to borrow money on the credit of the United States”. It is an important and critical pillar of our government’s balance of powers. In 1917, in the face of more frequent government financing needs – World War I - the 65th Congress, in conjunction with the Second Liberty Bond Act, delegated authority to the Treasury Department to borrow, subject to a limit. This action replaced the necessity of having to seek congressional authority on each issuance thus providing an operational convenience. Through the years, the format of the debt limit has changed. Initially, different types of government debt had their own limits. The debt limit essentially achieved its modern form in the early 1940s.

The debt limit currently stands at $7.384 trillion. Debt subject to limit, as of June 20th, was $6.598 trillion in combined publicly held and intra-governmental debt outstanding. The current definition of debt subject to limit lacks economic coherence. As stated, the debt limit applies not just to debt held by the public, but to the notional credits in the government trust funds, of which Social Security is the largest. An impartial party to the issue might logically prefer to alternatively define the debt limit as applying just to debt actually held by the public which is only 58% of the current limit. They may just as likely think it more reasonable to define it as a full measure of the government’s unfunded liabilities, in which case the current debt subject to limit is massively understated. Today’s debt limit is a halfway house, neither here nor there. Further, despite the debt limit’s conceptual emptiness, the steady growth of the trust funds - from less than 25 percent of total federal debt in 1990 to 43 percent in 2002 and projected to rise to 55 percent by 2007 - guarantees perennial debt limit strife no matter how frugal Congress chooses to be in the budget process.

This well intended “operational convenience” of 1917 has evolved to - at best – an operational inconvenience or - at worst - a threat to the high credit and financial standing of the United States government.

Risking the U.S.’s privileged standing in the capital markets

During the most recent episode, lasting from February 20 – May 23, 2003, Treasury was forced to use – as have all the administrations before us - what’s becoming euphemistically know as its’ “bag of tricks” to technically stay under the debt limit. All of these devices are provided for in statute. Most are “harmless” accounting “conveniences”. However, there always comes a point where use of other authorized devices, along with implementing unexpected alterations or opaque changes to Treasury’s “regular and predictable” issuance, have imposed costs on US taxpayers - and worse – short-term disruptive effects on the efficiency of the US fixed income market.

For example: (1) the June 2002 2-year note auction was delayed due to last year’s debt limit impasse (in which the US was placed on “credit watch” by Moody’s) and following a sloppy “snap” auction ended up costing the Treasury –taxpayers – an estimated $20-$30 million in higher interest cost, and (2) this year, T-bill issuance sizes were affected by $30-$40 billion in April, May and June as Treasury swung “compensating balances” in and out of the banking system to avoid the debt limit. This undoubtedly contributed to unusual tightness in the bill market in May.

The bill issuance adjustments during the recent debt limit episode still have some lingering market effects as we continue to work to “clean up after the party”. As the Wall Street Journal said in a recent editorial, “It would be worse than ironic if, while trying to hold down the level of debt, Congress actually raises the cost of borrowing”. The United States government enjoys unparalleled access to the capital markets in large part due to its regular and predictable policy. The market rewards Treasury for regular and predictable auction cycles with low cost financing. A higher cost of borrowing is likely to be realized when Treasury is seen to have deviated from its policy and introduced uncertainty into the market. While difficult to estimate, a move or a “risk premium” as small as 1 basis point would cost taxpayers $50 million/quarter or $200 million per year based on our projected issuance calendar.

It is critical that there be no doubt either here or abroad that the federal government will honor its financial obligations. In 1919, Moody’s Investor’s Service gave its first review and rating to U.S. Government securities – “Aaa.” The full faith and credit of the United States of America is one of the most precious assets that the American taxpayers have entrusted to any Congress and any Administration. Neither Congress nor the Administration wants to be blamed for losing this standing or much less default. However, the risks of a miscalculation inherent in the “political theater” of raising the debt limit, “getting it done only when it must be done”, may be more significant than all parties realize.

Is there a better way?

The U.S. capital markets are the envy of the world. The liquidity and transparency that exist makes our markets a role model for developing markets everywhere. However, as we watch that emulation take place, noticeably absent from the blueprint of any other government’s financing plan is the adoption of the debt limit concept as we entertain it. Varied voices in private and government sectors have questioned the usefulness of the debt limit. They are convinced that Congress, through its regular budget process, already has ample opportunity to vote on overall revenues, outlays and deficits. Still, it is critical and appropriate for Congress to maintain and exercise its constitutional granted authority and control for borrowing on “the full faith and credit of the U.S.” Yet there must be a more appropriate alternative mechanism to provide Congress a “check” on its delegation of borrowing authority to the Treasury. There must be an alternative to Treasury being periodically undermined of its ability to efficiently execute the assigned responsibility to manage the government’s cash and debt management needs.

Finding those alternatives is today’s challenge – “we need to fix the roof while it’s not raining.” Proposals to raise or repeal the debt ceiling are easy targets for demagoguery. Unless carefully explained – maybe even if carefully explained – these proposals are likely to seem profligate to many voters. A reform proposal will be most likely to succeed and deflect unfair attacks if it self-evidently bolsters fiscal discipline. As examples, alternatives to the current debt limit for consideration could include: (1) simply apply the limit to only debt held by the public or (2) tie a notional debt limit to a new metric, such as publicly held debt as percentage of Gross Domestic Product, now 32%. Or (3) Congress could also replace or redefine the debt limit. To serve as a genuine limit, a replacement should tie raising the debt ceiling directly to fiscal decisions, and define “debt” in a fiscally meaningful way. In an accrual based budget rule, Congress would have to raise the debt ceiling before making fiscal decisions projected to breach it – especially if debt subject to limit were calculated on an accrual basis. Under an accrual-based rule, expenditures are recorded, in whole, as soon as Congress approves them. Or (4) Congress could do away with a notional debt limit and grant the Treasury “evergreen” borrowing authority, that is, the authority to borrow as needed to fund congressionally approved expenditures subject to a periodic review. Congress could vote to renew this authority every 4 or 5 years. Any of these approaches, while still with drawbacks of their own, are far superior to the current status quo.

An active financial market community voice must not be mute in urging a solution to this problem

We at Treasury have worked especially hard over the past two years to make our deliberations more open and transparent and ourselves more accessible to dialogue with market participants – sell side, buy side, analyst and academia. Your input and feedback into our decision making process is wanted and critical to achieving our goal of “lowest cost financing over time.” The Treasury’s management of the government’s finances, as well as legislative policy affecting the execution of Treasury financing, should not be a spectator sport. It matters to you how our decisions on debt issuance – size, term, frequency, and distribution between nominal & TIPs - affect the efficiency of the market. It should matter just as much, if not more, that there not be counterproductive, obsolete legislative constraints which only serve to induce inefficiency and uncertainty into that same market.

Conclusion

Congress’s constitutional authority over borrowing is sacred but so too is the premier position of US Treasury securities in the world market place. A better way to maintain both must be found so that neither is compromised. Two hundred and twelve years ago, Alexander Hamilton’s idea of unitary government financing began Treasury’s responsibility of debt management with a portfolio of $75 million. One hundred and six years later –1897 - the national debt stood at $1.8 billion. And now, one hundred and six years after that, it stands at $6.6 trillion. In the face of this rising debt, the United States has witnessed unrivaled economic growth and development during those 212 years. The issue is misplaced. It’s not about debt and debt limits. It’s about economic growth. There – another myth exposed to the truth.

Thank you.