Thursday, October 24, 2013

Government Default, Risk-Taking, and Knowing What You're Getting Into

-- Posted by Neil H. Buchanan

In my Verdict column today, I suggest a way that President Obama could act now to defuse future debt ceiling crises.  Yes, it obviously involves invoking the Buchanan-Dorf trilemma analysis, but the question is how the President could act on our argument.  I recently concluded that "most of the debt ceiling debate is obviously about framing the issues," so I have been thinking about the supposedly "practical" objection to the notion of issuing debt in excess of the debt ceiling.

To get to that point, however, I spend the bulk of today's column arguing that President Obama's stare-down strategy for dealing with the Republicans in the last two iterations of the debt ceiling standoff has not permanently scared the Tea Partiers away from future standoffs.  Some people claim that the specter of the mid-term elections in November of next year will stop the Republicans from using the February 7 return of the debt ceiling to try to extract concessions from the President.

I am willing to believe that they will not shut the government down again, but there is every reason to believe that they view the debt ceiling issue as a political necessity.  As one report recently put it: "Surrounded by a hostile White House and Senate, and with few legislative avenues beyond borrowing and spending bills to impose their agenda, Republicans said capitulating to Obama would cede to Democrats the only institutional authority Republicans possess."  They are delusional enough to think that putting the President in a trilemma is not only completely acceptable, but that negotiating over borrowing and spending bills is insufficient "institutional authority" to get their way.

If I am wrong about that, then the debt ceiling will be forever dormant, returning to its former status as an occasional annoyance that allows member of Congress to make unctuous speeches about fiscal rectitude.  If I am right, however, then sometime soon (probably in only a few months) we will be back where we were barely a week ago, trying to figure out what the President can do.

My argument in today's column expands on a point that I have made in a few places recently, which is that the stare-down strategy requires nerve-wracking photo finishes, whereas the best strategy would be to get in front of this issue months in advance.  How, then, could a President announce months in advance that he is putting in place plans to issue debt in excess of the debt ceiling (which Professor Dorf and I have referred to as Presidential Bonds), if it comes to that?  My answer: By framing it as a matter of personal choice, and the morality of making people pay for consequences that they could not have reasonably anticipated.

Essentially, the argument relies on a comparison of who might get hurt under different strategies, and assessing who should bear the risks and burdens of a possible default on federal obligations.  I argue that potential victims of default -- people with checks coming from Social Security, businesses who are to be paid for work performed under government contracts, holders of Treasury securities expecting scheduled interest payments, and so on -- would be forced by a default to become involuntary creditors of the federal government, waiting to be paid while hoping that the impasse is resolved quickly.

By contrast, who would potentially be hurt by issuing debt in excess of the statutory ceiling?  When commentators (and President Obama himself, as I point out in the column) argue that nobody would be willing to buy that debt, my response to date has been, in essence, "Rational investors buy junk bonds, don't they?"  My argument today extends that point, to say that this is a matter of people deciding in advance whether they want to engage in a contract with the federal government, knowing that the contract is of uncertain enforceability.

This is, in other words, a question of just deserts.  Those who might be the victims of default were told in advance that they would be paid in full, on time, and they had two hundred years of history backing up their belief that they could rely on that legal commitment by the United States.  If they were to suffer, it would be through no fault of their own, because a default would occur when it would be too late for them to defend themselves.  People who would buy risky bonds, by contrast, would know that they might lose that lottery, and they could bid on the debt accordingly.

One trivial response to this argument might be that there are no guarantees in life, and so people who rely on the federal government should not start crying if they do not receive payment.  Even if one were to credit that reductio ad absurdum argument, of course, it misses the comparative point: the likelihood, ex ante, that the federal government will default is much lower than the argument, ex ante, that the Presidential Bonds will not be honored.

And even if one argues that the "new normal" since the Tea Party ate the Republicans' brains should have put potential victims on notice that there might be a default (at least, for those whose obligations arose after early 2011), that still does not respond to the reality that the potential buyers of Presidential Bonds would be better positioned to be aware of the risks involved.  Moreover, potential buyers are exactly the people who buy and sell risky assets for a living.

The notion of "knowing what you're getting into," of course, comes up all the time in life, and therefore in the law.  The doctrine of reliance interests in contract law, for example, requires comparing relative degrees of reasonableness when people claim that the actions of other parties have harmed them.

On last night's "The Daily Show with Jon Stewart," they ran a segment showing the Wall Street cheerleaders on the TV business channels expressing outrage at the idea that JPMorganChase will be paying a $13 billion fine, a chunk of it for the wrongdoings of Bear Stearns and Washington Mutual, two companies whose misdeeds occurred before they were bought (at fire-sale prices) by JPMorgan.

Stewart rightly mocked the talking heads, who were actually trying to argue that JPMorgan should not be punished for the wrongdoing of others.  The larger point (and, of course, Stewart's staff had damning video clips from the relevant time period) is that JPMorgan knew in advance that the law clearly requires buyers of such firms to assume the liabilities that might arise from the companies' prior actions.  Indeed, this is such a bedrock concept in American law that it is laughable that the pro-Wall Street hacks on CNBC and Fox Business would even try to suggest that it was somehow morally shocking.  It turns out that JPMorgan, like any organization with an even mildly competent legal staff, set aside funds to deal with the potential losses for which the firm might ultimately be found liable.  This is easy stuff.

Another area in which people misunderstand this is when they complain about institutional liability for college sports programs.  Whenever a university is hit with sanctions for past misbehavior by coaches, alums, boosters, or some other miscreant, the cry is almost always heard that (especially if the coach or player has since left the school) it is wrong to hold the institution responsible.  Beyond the goal of setting appropriate incentives for institutions to control their employees, this argument is absurd simply as a matter of considering who is taking risks, and with what kind of prior knowledge.

The most sympathetic version of the argument is that "the kids there right now didn't do anything wrong, so why are you taking something away from innocent victims?"  The fact, however, is that everyone knows that big-time programs can be hit with these types of sanctions, such that this is a known risk of joining any such program.  When, as in this week's sanctions against the University of Miami, the punishment follows a multi-year investigation, that risk was even more obviously both knowable and known.

Moreover, saying that "these kids didn't do anything wrong, so it's wrong to make them suffer with the institution," ignores the flip side: "These kids didn't have anything to do with turning the institution into the global brand that it is today."  When a high school senior excitedly signs up with Notre Dame, or USC, or Oklahoma, they are signing up to enjoy the perks that come with being part of an institution that provides things they cannot get elsewhere.

Admittedly, this example is far afield (no pun intended) from the debt ceiling and Presidential Bonds.  The broad point is that there are plenty of situations in life in which people have to assess the possibility of things going wrong, before entering into situations that entail making sacrifices in return for promises of future benefits.  There are close cases, and there are easy cases.

It should be easy for a properly motivated President to make the case, based on morality, that defaulting on federal obligations falls well outside the acceptable range of "making people pay for what they should have known they were getting into"  -- especially when there is an alternative group of people who could be brought into the situation with full knowledge of the risks that they would be facing.

This President shows no sign of being motivated to do so, but that merely means that he is willing to risk another default crisis, because he is too timid to take even the risk of saying: "Given the choice between stiffing people who would be blindsided, or possibly stiffing people who volunteered to take the risk, my decision is easy."


Michael C. Dorf said...

Very interesting points. I've been thinking about the game theory of this and it's not clear to me that Obama is wrong to reject our advice, however, at least at this point.

Suppose the President announces today that if Congress doesn't raise the debt ceiling by the next deadline, he'll issue Presidential bonds. I think that makes it more likely that Congress in fact fails to raise the debt ceiling, because the congressional actors are on notice that such a failure will not result in default. The question is whether the higher probability of debt ceiling impasse times the harm (in the form of higher borrower costs for the federal govt) of issuing Presidential bonds outweighs the lower probability of a debt ceiling impasse absent the announcement times the harm from a post-impasse default. I think that your/our proposal carries less probablistically discounted risk than the alternative--but not if Obama is bluffing. In order to get Congress to raise the debt ceiling, he needs to insist that there is no alternative to default but secretly plan to issue Presidential bonds if Congress really does fail to raise the debt ceiling.

Neil H. Buchanan said...

It's fun to have an intra-author dispute, although obviously this is on a point that is not at all central to our analysis.

In any case, I think the risk-adjusted costs and benefits have to include the harms that come from situations like the one we just went through. That is, it's not just assessing the risk "times the harm from a post-impasse default" that matters in assessing Obama's strategy, but the costs inherent in the white-knuckle, last minute brinksmanship that Obama's strategy absolutely requires. We are now seeing those estimates roll in, and they're not trivial.

Also, I'm not convinced that the risk of Congress failing to increase the debt ceiling goes up with a Presidential preemptive announcement. There is at least a colorable argument that there would be no point in holding the debt ceiling hostage, if everyone knows in advance what will happen, and the markets are given ample notice and are able to make it clear what the added costs to the government would be. The only reason to force an impasse at that point would be to try to "win the politics," but in the absence of a big market hiccup, where is the political traction coming from? "Obama violated the Constitution!" Yes, but see Buchanan-Dorf (and, at that point, everyone who no longer feels compelled to toe the Administration's current line).

I'm not saying it's impossible that it could come out the other way, but I think that even the direction of the change in probability unknown.

Given all that, even though Professor Dorf is obviously framing the question correctly, I'm less convinced than he is that the game theory supports BHO's current position.

David Ricardo said...

I think Mr. Buchanan is correct in that if the President were to decide to ignore the debt ceiling he must educate the country along the lines of the Dorf/Buchanan analysis, but I also think that Mr. Dorf has the better argument here. One has to ask the question, why did the Republicans blink and agree to raise the debt ceiling? The answer is that they believed the President would allow the country to default.

If Mr. Obama were to declare he would not allow default, then the motivation of the House Republicans would be to not raise the debt ceiling. They would justify this by proclaiming that not raising the debt ceiling would do no harm, as the nation would not default, and then after doing so take the political position that the President has violated his oath of office by not adhering to and obeying and enforcing the law of the land. Yes this would be logically inconsistent, but when does that matter to House Republicans? N the end the nation has a huge political fight it does not want and probably does not need.

I would repeat my suggestion made earlier, that if Mr. Obama wants to violate the debt ceiling he needs the protection of the courts. One way he might do this (and there are probably others) is that if Congress did refuse to raise the debt ceiling, the Sec. of Treasury could announce that based on the Dorf/Buchanan argument and others he was going to issue debt in excess of the debt ceiling. At that point Mr. Obama could instruct the Attorney General to bring suit against the Sec. of the Treasury in district court and ask the court to enjoin the Sec. of the Treasury from issuing debt. The Secretary of the Treasury could respond by asking the court to allow him to continue issuing debt until the issue was resolved, and under the argument that irreparable harm would result if the nation defaulted and that the Sec. of the Treasury might prevail, the Secretary would be allowed to issue debt until the issue was ultimately resolved, probably by the Supreme Court.

But this would all take place only after it the Congress refused to raise the debt ceiling. Given the Republican acquiescent that just occurred, this is possible but unlikely if Mr. Obama plays the game in the future as he has just now, and does not revert to his 2011 strategy, which all admit was a colossal mistake.

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