DRI-266 for week of 10-13-13: Don’t Raise the Debt Limit

An Access Advertising EconBrief:

[The following was completed one day before the debt-limit deal between Congressional leaders was announced on Wednesday, October 16, 2013.]

Don’t Raise the Debt Limit

The political melodrama now unspooling in Washington, D.C. is unique because it is playing on split screen. Our point of focus is the government shutdown – or rather, the partial shutdown, since somehow we just can’t seem to get the federal government shut down no matter how hard we try. Somebody can always find an excuse to fire up the machinery of government, cut checks, get them signed and sent out for some ostensibly vital purpose.

Meanwhile, up in the corner of our field of vision, always distracting our attention even though not occupying it fully, there is the debt-limit crisis. October 17 is the deadline for Congressional approval on raising the limit on the total volume of federal-government debt, thereby clearing the way for Treasury borrowing to finance expenditures in excess of revenue collections. The party line has it that failure to increase the debt limit by that date will put the U.S. government in “default” of its financial obligations to holders of its debt. The implication is that we have to borrow more money to pay the interest on the money we have already borrowed.

And what happens if we default on our debt? Well, opinions vary. They vary from “financial disaster” to “the end of life on earth.” According to Warren Buffet, the threat of default “should be like nuclear bombs… it should never be used.” Lloyd Blankfein of Goldman Sachs declares gravely that default would be “magnitudes worse” than the current shutdown in its effects. Perhaps sensing a need for escalation, former Treasury official and current BUP Paribas SA executive Tim Bitsberger ups the ante by stating that default “…blows Lehman out of the water” in its potential effects, implying that the 2008 financial crisis would be dwarfed in comparison.

Alternative to Default: Sales of Federal-Government Assets

If we’re not to default, what are we to do? En masse, the Democrat Party wants to simply raise the debt limit enough to get by the current fiscal year. That is what Congress has been doing for decades. That is what has enabled the culture of tax-and-borrow-and-spend – a culture that has made Washington, D.C. and environs the most prosperous, recession-proof habitation in the nation. Gradually, the Republican Party has evolved into a go-along-to-get-along enabler to this culture. They have tolerated vocal dissenters among their ranks because that provides convenient cover for the tacit collusion of the majority with the Democrats.

The recent emergence of the Tea Party and current mutiny led by Sen. Rand Paul and Congressman Ted Cruz has discomfited veteran Republicans almost as much as it has their opposition. But the mood of the general public – on both the political right and the left – is so dissatisfied with the status quo that the pols are bent on preserving that they are reluctantly contemplating the need for some sort of change. At the moment, though, the problem is getting past the immediate crisis.

That is now the motif of the governing process: a calendar dotted by scheduled crises and spotted by unscheduled ones. Its momentum is best characterized as a stagger from one crisis point to the next.

On the one hand, the Establishment – consisting of most of Congress and the entire Executive branch, plus all the bureaucrats, rank and file employees, lobbyists, contractors and news media – maintains that the only option is to raise the debt limit. They say this because the increase is the only option that would keep their world intact – at least for awhile. The alternatives would shake its foundations or topple them.

The general public is largely unaware of any third option beyond increasing the debt-limit and default. That is by design. The Establishment views any option averse to the current spending culture the way a vampire views the dawn.

Yet there is such a third option. It sticks out a mile. It is the option customarily exercised by private businesses overburdened with debt.

The federal government owns a huge portfolio of assets, both liquid and non-liquid. Its total value can only be estimated, but it is only modestly less than the estimated value of privately owned U.S. assets. The most cogent approach to the immediate – debt-limit – crisis is to begin selling off those assets to fund government operations. Government assets are more than ample to support annual operations, particularly due to the sequester’s success in temporarily reducing the deficit for this fiscal year.

Every year, some private companies work their way out of trouble this way. The key is acknowledging the company is in trouble, then taking steps to dig it out of its hole, rather than doing business as usual and hoping for miracles. Today, the federal government (along with many state governments) is in trouble. Like many corporate conglomerates, it is bloated and over-extended. It needs to stick to its core businesses and sell off its conglomerate holdings to those who can preserve them and make them pay off.

Over the course of this fiscal year, branches and agencies of the federal government can concentrate on raising revenue by selling liquid and non-liquid holdings. Meanwhile, Congress can tackle the job of cutting spending – a task too time-consuming to consummate prior to October 17.

And speaking of October 17 – the date itself has very little meaning once it becomes known that the government is selling assets and revenue is assured. Creditors – even bondholders – are more than willing to wait for a payment they know is coming, as opposed to a situation when everybody knows that incoming revenue is insufficient and somebody will inevitably get stiffed. That is why the option of asset sales is a viable way of rejecting a debt-limit increase.

The last thing Republicans should do is to raise the debt limit. This is an act of surrender to the spending culture, a can-kicking capitulation to the Establishment. It is not the failure to raise the debt limit that is irresponsible; it is the act of raising it that throws responsibility to the winds.

Estimates of the Federal Government’s Assets

At various times, estimates have been made of the federal government’s financial and tangible assets, both liquid and non-liquid. Despite the fact that they were often made when annual deficits were higher than the one projected for the coming fiscal year, the estimates invariably found that assets sales could easily support annual government operations.

Using mostly Treasury and Federal Reserve data from 2011, economist Robert Murphy identified federal government liquid assets of about $1.6 trillion. In June, 2011, the Treasury reported “international reserve assets” of $144.2 billion. They consisted of gold, securities, foreign-currency deposits of euros and yen, Special Drawing Rights [an international asset provided to governments by the International Monetary Fund] and IMF reserves. (The IMF assets were developed specifically to provide liquidity in emergencies like this one.) The official valuation is distorted, since the government’s 261.5 million troy ounces of gold was valued at a par value of $42.2 per ounce rather than its then-current market value of $1500 per ounce.

We can update Murphy’s numbers with some back-of-the-envelope calculations. Adjusting the numbers using a current gold price leaves non-gold assets of approximately $133 billion and a true valuation of roughly $337 billion in gold, yielding liquid assets of $470 billion+. Subsequently, gold has declined while the yen and euro have fluctuated in value. A current estimate of $450 billion would be conservative.

The Strategic Petroleum Reserve held about 726 billion barrels of recoverable oil. At today’s price nearing $100 per barrel, that would be worth about $72 billion. But since the oil is actually buried in salt caverns, Murphy suggested a discount of 25% to reflect recovery costs and time. Tack on another $58 billion to our current liquid-asset total, then.

The federal government owns offshore oil deposits whose estimated recoverable reserves total some 59 billion barrels. Murphy estimated the royalty income in years 8-38 of recovery at about $14 billion per year. He discounted that income at 5% and came up with $164 billion, which is an estimate of what the government might receive from selling the rights to that revenue for a lump sum.

So far, we have come up with nearly $675 billion. Murphy also found some $786 billion in “credit-market instruments” in Federal Reserve documents. These include $138 billion in agency-backed and GSE-backed securities and $355 billion in student loans. This total is much larger now, since the Fed has been buying mortgage-backed securities in order to support their market prices. He also included $55 billion in corporate (TARP) equities, which have mostly since been sold back into private hands. If we assume the changes cancelled out, we can stick with Murphy’s original $786 billion.

That produces somewhat less than a trillion and a half, far above the anticipated $650 billion deficit. It is reasonable to assume that the mortgage-related securities would be sold slowly over the course of the year and the full holdings might not be depleted, so as not to depress mortgage prices unduly.

We have not yet even touched the federal government’s huge land holdings. The government owns most of the state of Nevada, for example, among its 650 million acres of land. A couple years ago, then-OMB head Peter Orszag estimated that there are some 14,000 “excess” structures and 55,000 un-utilized or under-utilized structures and buildings in the federal government’s portfolio. These could and should be sold. The government’s power-generation facilities and the electro-magnetic spectrum are other lucrative holdings that are ripe for sale and privatization.

If we were to construct a net worth statement for the federal government, the bottom line would probably astound most Americans. Financial analyst John Rutledge has occasionally attempted it and come up with government asset valuations of between $150 and $200 trillion. (He estimates the value of private U.S. assets at $230-$250 trillion.) Thus, the potential for solving our debt problem completely by selling assets is clear. Of course, this would involve various technical and logistical complications. It would unquestionably alter the fundamental character of the federal government as it exists today. But isn’t it about time to do just that?

Arguments Against Selling Federal-Government Assets

The foregoing is persuasive. But it is only natural to wonder what drawbacks might lurk under its surface. In 2010, Treasury Secretary Timothy Geithner responded to calls for asset sales by pooh-poohing the idea. Holding a “fire sale” of government assets would damage “financial markets and the economy and undermine confidence in the United States,” Geithner maintained.

Each of these contentions deserves some scrutiny. It is perfectly correct that when a company starts selling assets, it tells the world that it is in trouble and it runs the risks that this knowledge will have adverse effects. Among other things, the company may now have more trouble borrowing money and its stock price may well decline (assuming the stock trades publicly). But these are not fatal flaws, merely tradeoffs; they have to be weighed against the risks of inaction.

The drawbacks of straightforwardness do not tell nearly as heavily against a country as against a single company. A company can sometimes hide its financial condition from the public and the markets, but a country can’t. We aren’t fooling anybody by sitting on our gigantic stockpile of assets; our credit rating has already been downgraded and our debt and deficit problems are open secrets. Sooner or later, our interest rates are going to rise – the only question is how much debt is weighing us down when they do. The world will have a lot more confidence in a United States that has finally started whittling down its debt than one that has buried its head in the sand while continuing to spend itself silly. This assessment is not merely speculative; two days before the financial equivalent of “Mayan calendar” oblivion, a Wall Street Journal headline reads “Uneasy Investors Sell Billions in Treasurys.” Apparently confidence in the debt-limit-raising approach is not exactly unshakeable.

Geithner’s warning about “damage to the economy” presumably derives from the Keynesian concept that government sales of assets to the public drain money from the circular flow of income and expenditure, thereby reducing income and employment. As Murphy points out, this requires us to believe that people would rather end the year with $650 billion or so of IOUs than $650 billion worth of valuable assets formerly managed (often mismanaged) by the government. How could asset sales “damage the economy” as much as the status quo of wasteful spending and debt accumulation?

There is at least some superficial cogency to Geithner’s concern about financial markets, since some of the liquid assets in the federal portfolio were purchased in the first place to prop up the asset’s price. Clearly, selling will have the opposite effect, especially in quantity. This is why sales of mortgage-backed securities would presumably be strung out over long time periods, although the anticipation of continued sales would have the effect of driving down prices in advance of sales anyway. But the real issue is the legitimacy of the price itself. In effect, Geithner is admitting that the so-called housing “recovery” is really an artifact of government contrivance and will evaporate without it. How long is this supposed to go on, anyway? Is the tail of the housing sector supposed to wag the general economic dog forever? Orderly asset sales would seem the indicated exit strategy for this misguided policy.

Democrat arguments against government-asset sales are a pretext. The sales would represent a turning point in over a century of big-government, “progressive” policy. According to progressive doctrine, government is supposed to accumulate power, control and authority – not cede it.

The ironic thing is that asset sales would leave the skeletal structure of big government intact. The entitlement programs – Social Security and Medicare – would be untouched. Most of the regulatory agencies would be unaffected; only those entrusted with caring for assets that were sold off would be downsized or eliminated. (A major benefit of selling assets would be that the overhead expense of minding them could be offloaded.) Yet this minor impact on the welfare state has little effect on the Democrats’ intractable opposition to the idea. The fact that government does a perfectly terrible job of managing assets is also completely beside the point. Democrat policies are inherently designed to exploit the many for the benefit of the few and this demands not only big government but continually expanding government. Anything that threatens that, threatens their livelihood.

Hole Card?

A recurring theme among reactions to the prospect of default is incredulity that Congressional negotiators (read: Republicans) would be so reckless as to tempt fate by flirting with the debt-limit date. How dare they run even the tiniest risk of default?

For several years, the Federal Reserve has already been doing the unthinkable, more or less in plain sight but without provoking the same sort of outrage from the business and financial community. It has been “monetizing the debt” by buying new issues of federal-government debt directly from the Treasury using newly created money for the purpose. That activity has been technically illegal throughout the Fed’s existence, but the Fed circumvents the intent of the Federal Reserve Act by acquiring new issues directly from the primary dealers who transact directly with the Treasury. This was an important part of the QE (quantitative expansion) policy, which was designed to keep the federal-funds rate (thus, short-term interest rates in general) as low as possible. If the rest of the world was becoming reluctant to take on more and more U.S. debt – why, then, the Fed would just have to step into the breach. After all, it’s not as if the federal government should actually have to cut spending, is it?

Of course, there was the little matter of all that money that the Fed created. Ordinarily, the money would have had a multiple effect on the total money stock. The Fed formerly did its bond buying in the secondary bond market for the express purpose of creating reserves for banks to use as a reserve base for pyramiding loans to businesses and households. (Students will recognize the term “money multiplier,” used to estimate the amount by which the money stock increases based on an initial injection of money.) When the money was spent, this effect produced economic effects extending beyond the initial recipients of the spending. The trillions of dollars the Fed has recently created (some of which has financed U.S. government debt) would be sufficient to kindle hyperinflation when fed through an ordinary market process. Throughout history, this kind of money-creation has been considered strictly “the policy of the desperado,” as F.A. Hayek called it. Allan Meltzer, whose multi-volume history of the Federal Reserve has cemented his reputation as perhaps the world’s leading monetary economist, admits that despite his personal liking for Ben Bernanke, “It’s pretty hard for me to argue that if you have a few trillion dollars of excess reserves in the banking system, you think you’re doing it for the good of the economy.” Once again, though, the Fed has escaped censure for its actions thus far.

Doubtless this general insouciance is explained by the results. The created money and/or its loan potential has mostly sat idle in bank excess reserves, because a law change allowed the Fed to pay interest on money held in excess reserves by its member banks. Meanwhile, the bonds themselves have been quietly added to the Fed’s portfolio, where they have been quietly drawing interest. The Federal Reserve has now become one of the world’s leading holders of U.S. debt.

This raises an interesting possibility. Even though the Federal Reserve is a bank and operates as such, earning profits and suffering losses on individual transactions, it is not an ordinary bank. One quaint feature of its operations as a “quasi-public” institution is that it remits interest earned on its holdings of federal-government bonds to the Treasury. (It does this in spite of the fact that the Federal Reserve System is composed of its member banks and the Fed presumably has a fiduciary responsibility to them.) Thus, when the Fed buys bonds from the Treasury and holds them, that means the Treasury is getting interest-free financing for its deficit expenditures with money the Fed creates.

This raises the possibility that the Obama Administration’s debt-limit hole card may be an arrangement with the Fed that it will buy up all new debt in the coming fiscal year – and maybe more besides. Remember, the Fed was widely expected to end its program of quantitative easing in September, but continued it unabated, confounding markets and the public. Its explanation for this was confused – even normally tame Fed-watchers criticized Bernanke for leaving markets in the lurch. Remember, also, what everybody is most worried about – that default on our debt will take away the U.S. government’s ability to borrow.

Preempting the bond market is not something the Fed would normally be happy to do. U.S. Treasury bonds are traditionally one of the world’s leading fixed-income assets. People line up to buy them. Frustrating this demand would be unprecedented. But recently the Fed has been buying most of the new Treasury debt anyway; Bloomberg estimated that in 2012, the Fed was starving the market for Treasurys by soaking up 90% of new issues. In any case, the prospect of a debt default might be considered a big enough emergency to justify such high-handed action. And the Administration would be willing to consider any alternative to spending cuts or asset sales, as explained above.

The Fed’s actions are so outré and its politicization so apparent that this kind of hidden agenda makes about as much sense as any other explanation for its actions. It isn’t as if Bernanke’s tenure thus far has been squeaky clean and free of any taint of political collusion. Quite the contrary.

And this theory doesn’t argue in favor of raising the debt-limit, either. Thus, the verdict on the debt limit is clear-cut: Don’t raise it.