Advancing a Free Society

Three Common Legal Misunderstandings About the Debt Ceiling

Thursday, July 28, 2011

Perhaps because the United States has so rarely hit the debt ceiling, there is a lot of misinformation about what it means. Here are three legal misconceptions I have observed in the news media and from politicians.

Hitting the debt ceiling is not the same as a “default.” Even in the (still unlikely, in my opinion) event we hit the debt ceiling without congressional action to raise it, this does not mean we would “default” on the public debt. It means we could not borrow any more. The Treasury will take in something on the order of $175 billion in revenue during August, and this is more than enough to pay the interest and principal on bonds as they become due. Hitting the debt ceiling would mean we could not pay for all the appropriated spending scheduled to take place in August. If the debt ceiling were not increased, Treasury would have to take steps to reduce expenditures (such as furloughing non-essential employees, closing unnecessary facilities, and holding back discretionary grants) and to postpone payments on current obligations (such as payments to government contractors, refunds to taxpayers, and the like). But if Treasury officials are prudent, and I think they are, they will prioritize payments and they will not default on the debt. In fact, if the recently much discussed Section Four of the Fourteenth Amendment has anything to say about this matter, it means that it would be unconstitutional for the Treasury to fail to prioritize payments on the debt over other expenditures.

Hitting the debt ceiling will not require suspension of payment on Social Security. For reasons I have explained on this site before, the government will be able to make Social Security payments even if the debt ceiling is not increased. The Social Security Trust Fund holds over $2 trillion in special Treasury securities, which it is legally entitled to redeem when necessary for the payment of benefits. When the Treasury redeems those bonds, the public debt will correspondingly be reduced, which will enable it to auction new bonds to investors, without violating the debt ceiling. This is precisely what happened during the debt ceiling crisis in 1985. Then, it was a Democratic House of Representatives that refused to raise the ceiling at the behest of a Republican President (an episode conveniently forgotten by those who wish to paint the Republican House today as uniquely evil for insisting that a debt ceiling increase be accompanied by spending reductions). The Social Security trustees cashed in some $9 billion in special Treasury securities for the payment of benefits, and the Treasury auctioned off the same amount in new U.S. bonds, without violating the debt ceiling. Here is how the Comptroller General described the event:

The Treasury Department estimated that it would have insufficient cash on November 1 to pay social security benefits and other government obligations. In order for these payments to be made, the Treasury needed to borrow money from the public, and in order to borrow the money, Treasury had to reduce its outstanding debt below the statutory limit. Therefore, on November 1 the Secretary redeemed $9.613 billion of the Trust Funds’ long-term securities, and $1.9 billion of securities held by certain other government-managed trust funds, to permit public borrowing of about $13 billion.

In this way, the Reagan Treasury was able to continue to pay Social Security benefits without interruption, despite the failure of Congress to raise the debt ceiling at the time.

The Comptroller General ruled that these redemptions were lawful, except that the trust fund redeemed more securities than were actually necessary for the payment of benefits. Some years later, Congress passed a statute codifying the Comptroller General’s decision. Public Law 104-121, section 107(a), prohibits redemption of special securities held by Social Security prior to maturity for any purpose other than the payment of benefits or administrative expenses. This statute is significant for two reasons. First, it confirms that the trustees have authority to redeem the special securities prior to maturity for the payment of benefits, and second, it prevents the executive from using the trust fund as a massive kitty to avoid the effect of the debt ceiling.

The debt ceiling is a different problem than the debt. Some observers seem to think that the nation’s fiscal difficulties are caused by the debt ceiling, and that if only Congress would increase the ceiling all would be well. This is a misconception. The debt ceiling issue presents a liquidity problem; the debt itself presents a solvency problem. Debt rating agencies would surely be concerned if the Treasury slipped up on an interest payment because of a cash crunch. But the longer-term, more difficult, and more important problem is the rising level of spending and debt, which limits the futures of our children and grandchildren, stifles economic growth today, and puts into question, for almost the first time since Alexander Hamilton, the ability of the nation to service the public debt. Whatever the resolution of the current debt ceiling controversy, it is imperative that Congress bring spending back down to levels consistent with our ability to pay.