The Debt Ceiling: Can a Crisis Be Avoided?

Many are predicting a financial disaster if the U.S. Congress fails to raise the debt ceiling by October 17. Given the political volatility around the issue and the current government shutdown, a catastrophic outcome cannot be ruled out. But a deep financial crisis is unlikely, because President Obama and the Treasury Department have many levers available to help them avoid worst-case scenarios, at least for the near term, says Wharton finance professor Franklin Allen in this podcast interview. Allen is co-editor of the recent book, Is U.S. Government Debt Different?

An edited transcript of the conversation appears below.

Knowledge@Wharton: We’re speaking today with Wharton professorFranklin Allen about the potential U.S. government default on its debt around October 17. Professor Allen is the co-editor of a recently published book entitled Is U.S. Government Debt Different?, which was published by the Wharton Financial Institutions Center and is available for free on its website. It’s a collection of essays written for exactly this kind of a potential crisis.

Franklin, thanks very much for joining us this morning.

Franklin Allen: It’s my pleasure, thank you.

Knowledge@Wharton: It appears the government shutdown issue is merging with the debt ceiling issue to create the mother of all debt confrontations. As we know, the U.S. government is set to run out of money around October 17 unless the debt limit is raised. So, putting the politics aside for now because they are, at best, murky, and based on the Wharton seminar on which your book is based, what do you think are the best-case and medium-case and worst-case scenarios for the outcome of this potential crisis?

Allen: Well, the best case scenario is that they do the deal and we’re finished with this in the next day or two. But I think that that’s unlikely to happen.

I think that the medium scenario is probably that this goes on for some time to come. I think the shutdown probably isn’t so damaging, especially since I understand that the Pentagon is sending 350,000 people to work, so that’s reduced the total significantly. But as the process indicates, the real action so to speak is in the debt ceiling and one of the interesting things that I think we learned from this conference is that there are ways for them to avoid default and I think that there are good reasons to do that. There’s a very interesting chapter in the book, Chapter Five, by professor Michael McConnell from Stanford University, which goes into the debt clause of the 14th Amendment and this is a part of our Constitution that says, to abbreviate it, the debt of the United States as it’s legally issued shall not be questioned.

Now there is an issue about what does that mean? But essentially, it is difficult for the government to avoid [making payments] or to default, because if there was any sense of that, even a technical default, I think that there would be constitutional issues raised and that would be difficult for the government. In Chapter Six, by professor Howell Jackson from Harvard University, he goes through scenarios about how the government can avoid default on the debt and essentially, what seems likely to happen if they don’t raise the debt ceiling and we go through that period up to the 17th … where the government can’t borrow anymore. Then, what’s likely to happen is some kind of modified first-in, first-out [accounting system] whereby all of the bills that come into the government will be placed into a pile, so to speak, and then as the money comes in from the tax revenue that will still be collected, then they’ll pay the bills that are at the top of the stack.

Now what happens, of course, since they can’t borrow and that pays a substantial part of our expenditures at the moment, is that the time it will take for people to get paid lengthens. They can prioritize various things and they can, in particular, prioritize the interest payments, so there’s no reason that we need to have a default. There’s plenty of tax revenue to cover the interest and so what will happen is that people will get paid, but it will take longer and longer, and I think the interesting question will be how the Treasury deals with that, whether they will try to send Treasury people to explain when they’re likely to get paid and whether they can take those [promises] to banks and borrow against them and so on. I think there’s little doubt that these people will eventually all get paid. The only issue is the timing of it. So I think that’s the medium scenario, which is that we can go on a fairly long time without the debt ceiling being raised.

Knowledge@Wharton: Some observers note that a failure to raise the debt ceiling would require an immediate cut in spending. So even if there weren’t defaults, there’s a paper out by Bank America Merrill Lynch that says if the debt ceiling is not lifted, then the U.S. would have to immediately cut its budget by about 20%, which is equal to about 4% of GDP. That would push the U.S. into another recession even if there were no default. What would be the consequences for the U.S. and world economies?