U.S. Default Is Possible: Treasury May Not Prioritize Debt Payments

If this isn't a bluff, then Washington's failure to strike a deal should deeply disturb the rating agencies, the market, and everybody else

590 capitol dark jim young reuters.jpg

Surely, the Obama administration will not allow the U.S. to default. Even if Congress fails to pass a resolution by the Treasury's August 2nd deadline (which is this coming Tuesday, by the way), surely the President will direct Treasury Secretary Geithner to prioritize debt payments above others so that the U.S. doesn't miss an interest payment. This has been a commonly held assumption of many following the debt ceiling fiasco -- and this is also what the rating agencies think. A new report, however, suggests that they could all be wrong.

Binyamin Appelbaum of the New York Times reports today that the Treasury will explain how it will pay its bills with insufficient funds later this week. But he also writes that we may already know the answer:

Officials have said repeatedly that Treasury does not have the legal authority to pay bills based on political, moral or economic considerations. It cannot, for instance, set aside invoices from weapons companies to preserve money for children's programs.

The implication is that the government will need to pay bills in the order that they come due. President Obama has warned as a result that the government "cannot guarantee" payments of Social Security benefits or other popular programs. Officials also have disputed the assertion of some Republicans that the government could prioritize interest payments.

Indeed, earlier this year one Republican, Sen. Pat Toomey introduced a bill that would have required the Treasury to prioritize debt payments above all others, in order to insure that the nation's pristine AAA-rating is preserved. The Treasury will have plenty of revenue to cover interest payments -- it just won't have enough to cover everything else as well without issuing more debt. Toomey's bill never passed.

But that didn't matter to the rating agencies. In June, I asked Moody's and Standard and Poor's whether or not a bill like Toomey's would ease their fears of default. They said no, because they already implicitly assumed that the Treasury would prioritize debt payments to preserve the U.S.'s rating.

And yet, the report above suggests that the agencies' assumption is incorrect. If the debt ceiling is not raised and the Treasury uses its consequently insufficient funds to pay bills as they come due in August, then before long an interest payment will be missed.

Is this a bluff by these Treasury sources or will the Treasury really shrug and default in a few weeks if no deal is reached? We'll know for sure in a few days when it releases an official statement. But this possibility shows how high the stakes are for the debt talks.

This makes Tuesday, August 2nd a pretty important date. Although some have suggested that the deadline isn't real, Treasury has repeatedly insisted that it is. Discussions I had with Treasury officials in May indicated that it would be illegal for them to fib about this date. That's why they were forced to extend it last spring from July 8th to August 2nd when higher-than-expected tax receipts came in. Obviously the administration would have found it convenient to instead leave the initial drop-dead date intact to provide a little extra cushion for Washington's politics, but the law wouldn't allow it. If the law similarly doesn't allow the Treasury to prioritize interest payments, then it won't.

If the rating agencies observe the Treasury state in an official capacity that it will not prioritize debt payments, then they should downgrade the nation's debt once it becomes clear that the U.S. will not reach a deal by its Tuesday deadline. A downgrade would be bad, but a default would be much worse. And unless some weird action is taken, like the Federal Reserve allowing the Treasury to carry a negative balance on its account for a time, a default may be unavoidable if Congress doesn't reach an agreement in time.

If the Treasury really can't prioritize payments, and it's pretty hard to believe that it wouldn't if it could, then a bill like Sen. Toomey's might be a good short-term solution to tide the markets over until Congress finds a way to compromise on a longer-term debt limit and deficit reduction plan. A default would be disastrous. If the Treasury doesn't have the legal authority to prioritize debt payments, then Congress needs to provide it the ability to do so.

Image Credit: Jim Young/Reuters