Wall Street counting on debt limit trick that may be risky

Washington’s debt limit drama has Wall Street betting the United States will employ a fallback option to ensure it can make good on payments to its lenders even if Congress doesn’t raise the nation’s borrowing limit before America runs out of cash.

But that untested idea has significant flaws and has been ruled out by the Biden administration, which could make it less of a bulwark against disaster than many investors and politicians are counting on.

Many on Wall Street believe the Treasury Department, in order to avoid defaulting on U.S. debt, would “prioritize” payments on its bonds if it could no longer borrow funds to cover all its expenses. They expect that America’s lenders — the bondholders who own U.S. Treasury debt — would be first in line to receive interest and other payments, even if it meant delaying other obligations like government salaries or retirement benefits.

Those assumptions are rooted in history. Records from 2011 and 2013 — the last time the U.S. tipped dangerously close to a debt limit crisis — suggested officials at the Treasury had laid at least some groundwork to pay investors first and that policymakers at the Federal Reserve assumed such an approach was likely. Some Republicans in the House and Senate have painted prioritization as a fallback option that could make failure to raise the borrowing cap less of a disaster, arguing that as long as bondholders get paid, the U.S. will not experience a true default.

But the Biden administration is not doing prioritization planning this time around because officials don’t think it would prevent an economic crisis and are unsure whether such a plan is even feasible. The White House has not asked Treasury to prepare for a scenario in which it pays back investors first, according to multiple officials. Janet Yellen, the Treasury secretary, has said such an approach would not avoid a debt “default” in the eyes of markets.

“Treasury systems have all been built to pay all of our bills when they’re due and on time, and not to prioritize one form of spending over another,” Yellen told reporters this month.

Perhaps more worrisome is that, even if the White House ultimately succumbed to pressure to prioritize payments, experts from both political parties who have studied the temporary fix say it might not be enough to avert a financial catastrophe.

“Prioritization is really default by another name,” said Brian Riedl, formerly chief economist to former Republican Sen. Rob Portman and now an economist at the Manhattan Institute. “It’s not defaulting on the government’s debt, but it’s defaulting on its obligations.”

Congress must periodically raise the nation’s debt ceiling to authorize the Treasury to borrow to cover America’s commitments. Raising the limit does not entail any new spending — it is more like paying a credit card bill for spending the nation has already incurred — and it is often completed without incident. But Republicans have occasionally attempted to attach future spending cuts or other legislative goals to debt limit increases, plunging the United States into partisan brinkmanship.

Today’s debt limit episode could be especially fraught, much like the 2011 episode that tiptoed the nation so close to the brink of default that America’s credit rating was downgraded for the first time. House Republicans have made clear they want to attach spending stipulations in exchange for raising the borrowing cap, while the White House has said it will not negotiate.

President Joe Biden and House Speaker Kevin McCarthy are expected to discuss the debt limit Wednesday.