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Net Net: Promoting innovation and managing change

Don't Listen to What Bond Market Says, Watch What It's Doing

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Don't be so sure that there won't be a market for unauthorized government bonds.

The question of unauthorized debt issuances could arise if lawmakers and the Obama administration cannot agree to raise the debt ceiling. The federal government could run out of cash to pay its obligations—although it's not clear that this would necessarily occur on Aug. 2, since the government could sell such assets as securities and gold held in Fort Knox—and yet be prohibited by law from borrowing.

In that case, some have speculated that the Obama adminsitration might just go ahead and issue debt anyway. A little known clause in the 14th Amendment to the Constitution may authorize—or even require—this. Or it may not. Legal scholars are busy fighting over it. The non-partisan Congressional Research Service says this wouldn't be allowed. So does Lawrence Tribe. Otheres disagree, arguing that the Constitution—which trumps the debt-ceiling statute—prohibits defaulting on debt.

(My own best guess is that the Treasury Department could issue debt without authorization, no one would have standing to sue to block the issuance, the Supreme Court would avoid getting involved by citing technical legal mumbo-jumbo, and then lawmakers would have to decide whether to try to impeach Obama or Geithner or both. And then this silly impeachment debate would wind up helping Obama secure a second term.)

But whether or not 14th Amendment bonds would be legal, many wonder if they are pratical.

Here's what Lawrence Tribe wrote on the op-ed page of the New York Times:

So the arguments for ignoring the debt ceiling are unpersuasive. But even if they were persuasive, they would not resolve the crisis. Once the debt ceiling is breached, a legal cloud would hang over any newly issued bonds, because of the risk that the government might refuse to honor those debts as legitimate. This risk, in turn, would result in a steep increase in interest rates because investors would lose confidence—a fiscal disaster that would cost the nation tens of billions of dollars.

Pardon me asking an impolite question: Since when did Tribe become an expert on the bond market?

Tribe knows more about the law than I would ever care to know. But I'm not sure legal expertise creates the ability to predict the reaction of the bond market to an unauthorized debt issuance.

Of course, it's not just Tribe who is skeptical that there would be a market for unauthorized debt. Lots of the Very Serious People who trade bonds have raised skeptical points as well. Megan McArdle sums up this view here:

I heard an analyst made a point about proposed 14th Amendment bypass of the debt limit, which was so obvious that I couldn't believe I hadn't thought of it: To wit, even if the Treasury simply went ahead and issued more debt, who was going to buy these instruments of dubious legality? And at what price? Yet all the DC people I'd seen writing about the "14th Amendment Solution" had focused on the legality of the move, or the political fallout; no one had thought about, like, finding customers for the debt.

Megan and Ezra Klein find this a very persuasive point. They're very concerned that Washington, D.C., isn't listening close enough to what these market experts are saying. (And that the bond markets aren't taking seriously enough the possibility of default.)

So let me be impolite again: Megan and Ezra are wrong. The last thing politicians should start doing is listening to what market participants say about bond markets. These guys have a terrible record at predicting how markets will react to events.

Take the now-famous example of PIMCO. The giant bond trading firm sold off its exposure to bonds in the months leading up to the end of the Fed's quantiative easing, and was very vocal about why it thought Treasuries would sell off when the Fed stopped buying. The market didn't listen to PIMCO, however. Treasury yeilds just kept on falling.

What seems to have caused the market to confound PIMCO's expectations was something that, in retrospect, is completely understandable. The end of quantitative easing made many in the market conclude that it was time to decrease risk and increase liquidity—and that is almost always a call for buying Treasurys.

And that might happen if we reach Aug. 2 without an agreement on the debt ceiling. Concern over the prospects for a U.S. default or downgrade could result in people buying more Treasury debt.

I know that sounds mind boggling. But it really isn't. Even if the U.S. were to be downgraded by Moody's and S&P, even if it were to skip an interest payment to a creditor who voluntarily waives receipt—"Mr. Secretary? You have Chairman Bernanke on line 2, again"—there's pretty much zero chance that the U.S. will not eventually make each and every one of its creditors whole. And even if the debt issued is of questionable legality, it will still be safer than anything else in the world.

This is what the bond markets are telling us, regardless of what the market participants are saying. Treasurys and show no default risk pricing.

If you want an extreme example of how confident the market is when it comes to the ability and willingness of the U.S. to pay, just look at the bond prices of banks. The largest banks—those bad, old Too Big To Fail (TBTF) monsters—have a distinct funding advantage over smaller, regular banks that can fail. The source of this funding advantage is the confidence of investors that the U.S. will bail out the creditors of these banks.

This confidence persists despite the fact that the U.S. not only has no explicit guarantee over these banks, it has an explicit anti-guarantee. Dodd-Frank declares that banks won't be bailed out. But the market has called the bluff of Dodd-Frank.

If creditors are still confident that the U.S. implicitly guarantees the debt of TBTF banks, despite an explicit policy otherwise, of course they aren't worried about the U.S. actually defaulting or repudiating its debt.

The U.S. has a long history, extending all the way back to the payment of Revolutionary War debts of states, of not only paying all of its obligations—but paying off many obligtations owed by others (banks, states, etc.). And bond markets have an equally long history of reacting to scary events by buying Treasurys. If we have a debt limit crisis, don't be surprised if that happens again.


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