Lessons from America's Last Brush with Default

Tory Newmyer Fortune April 25, 2011

By Tory Newmyer, writer

FORTUNE -- Here's the scene from 1995: A default on the federal debt is looming; young, newly-empowered Republicans on Capitol Hill are looking to use that threat as leverage to push their budget proposal; a Democratic White House is straining against their demands for major reforms in the name of deficit reduction; and the Treasury Secretary is broadcasting calm to keep the markets from spooking while trying, simultaneously, to impress the doomsday consequences of a default.

Sound familiar? That was the last time the United States seriously flirted with a debt ceiling collapse. The scenario, of course, is replaying now, as policymakers brace for the next installment of a partisan showdown over the size and scope of government. The feds are on track to reach their $14.29 trillion borrowing limit in mid-May, and the Obama administration says juggling accounts can only buy time until July 8. After that date, the government will default on its debt -- a nightmare event that would gut investor confidence in U.S. bonds, send our borrowing costs soaring, and in all likelihood, precipitate another global financial meltdown.

For months, the White House has been working behind the scenes to avert that outcome by lobbying for a simple, so-called "clean" hike of the debt ceiling. But Congressional Republicans are intent on demanding that any raise come with at least some of their deficit-cutting priorities. With market watchers nervously tracking the face-off as the clock winds down, it's worth taking a look back at the last time a political fight nearly ended in default.

Largely forgotten now, even inside the Beltway, that standoff on the debt limit actually framed what would become a much noisier fight over a government shutdown. Starting in the spring of 1995, then-House Speaker Newt Gingrich (R-Ga.) and his allies in the new GOP majority were plotting to use a vote on the debt ceiling to force President Bill Clinton to adopt their seven-year balanced-budget plan. The issue had prompted partisan skirmishes over the years, but what appeared to distinguish this round was that Gingrich and others in the GOP were actually threatening to follow through and force the nation's first-ever default if the White House didn't agree to its terms.

A quaint-sounding $4.9 trillion ceiling

Clinton administration officials, understanding the consequences of a default, had trouble believing that the Republicans could be serious. But then-Treasury Secretary Robert Rubin nevertheless moved to prepare for it. Early that year, he tasked Ed Knight, the department's chief counsel, with assembling a team of the best legal minds at Treasury and the Department of Justice. Their mission was to quietly explore Rubin's available legal options for continuing to meet the government's obligations beyond the ceiling.

The debate ramped up that fall as the $4.9 trillion debt ceiling swung into view. Publicly, Gingrich kept the heat on the White House by pledging not to blink. "I don't care what the price is," he said in a mid-September speech that year to a securities group. Privately, he was telling the administration that while he hoped to avoid an impasse, he wasn't sure he could contain the newest members of his own conference.

More than 150 mostly first- and second-term populist GOP lawmakers had organized themselves into the Debt Limit Coalition, vowing not to raise the debt roof until Clinton accepted the Republican budget.

Treasury officials had been reaching out to lawmakers in both parties and both chambers since the summer, trying to explain the stakes. "We didn't want to overly politicize it, but we did begin to quietly educate people," says Penny Rostow, Treasury's then-deputy assistant secretary for domestic finance and banking legislation.

John Hawke, then-under secretary for domestic finance, recalls briefing John Boehner, the fourth-ranking House Republican at the time, and finding him notably reasonable. "Some guys were rather truculent about it," Hawke says. But the current House Speaker, his party's point man in the coming debate, "was relatively easy to get along with. We had several meetings, and he's a smart guy, and he understood what the issues were."

The government hit the debt ceiling at the end of October, but Treasury had enough cash to keep things running until November 15. The game of chicken between Congressional Republicans and the Clinton administration continued to the brink of the deadline. On November 12, with no compromise in sight, Rubin decided to make use of an unprecedented emergency maneuver that Ed Knight had discovered, pulling $61 billion from two federal retirement accounts.

The move made use of a Reagan-era law designed to give that administration the authority to head off a similar threat from a Democratic-controlled Congress. Known as "disinvestment," it involved converting securities in the funds into cash, and effectively replacing them with IOUs to repay the sums later, with interest. The maneuver allowed the feds to meet obligations through the end of the year -- and freed Clinton to veto a temporary debt limit hike that Republicans had packaged with restrictions on Treasury's ability to keep dodging default.

The Treasury's equivalent of nuclear war

Rubin's gambit had a political impact, as well: it melted one lever Republicans were aiming to use to pry tax and program cuts out of the Clinton White House. "It created a fair bit of umbrage amongst those who thought they could force President Clinton into accepting their budget," says Rubin, now chairman of the Council on Foreign Relations. With the threat of default deflated for the time being, Republicans took the fight over their budget proposal to a parallel debate over government funding, prompting the first of two shutdowns that quickly came to dominate headlines out of Washington.

But while the debt limit debate moved off the front page, it remained a consuming preoccupation inside Treasury. Servicing the nation's debt is at the core of department's mission. A default, especially as a political statement, says Rubin, "should be absolutely unthinkable," and yet the threat was real. After blowing past the debt ceiling, senior Treasury staffers gathered daily in the conference room outside Rubin's office for afternoon meetings to review the latest news from the Hill, any progress toward new time-buying tactics, and overnight tax receipts, as a measure of how close they had moved to the edge.

And they also planned for what they would do if they careened over it. "It's a worst-case scenario," says Knight. "The Defense Department equivalent would be nuclear war." The mood inside the department was proportionate. Rostow recalls joking to Rubin at one point that people were going to start referring to Treasury bonds as "fallen eagles" -- a riff on "fallen angels," a Wall Street handle for junk bonds. Rubin didn't laugh. "He was really burned by the idea we might default," Rostow says.

On the Hill, meanwhile, Republicans were intensifying their attacks on Treasury. They howled that Rubin's maneuver ran afoul of the Constitution, which grants borrowing authority to Congress. In early December, Gingrich appointed a task force to explore suing the department. Some called for Rubin to resign; others talked about starting impeachment proceedings. But Knight's careful legal work withstood the assault, and Republicans never so much as filed suit.

That was the good news. The bad news was that Treasury was out of options for delaying a default. Rubin in mid-December bought the government's last extension by withholding a $14.5 billion year-end interest payment due to one of the funds, forestalling the crisis until March.

Then, in the New Year, the storm clouds started to break. Wall Street stepped up pressure on Republicans to back down, as Moody's and Standard and Poor's both issued warnings that the government's credit rating was at risk. More importantly, President Clinton had won the public argument over the government shutdown, and a weakened GOP suddenly lost its appetite for confrontation. In March, Republicans folded, agreeing to a long-term extension of the government's borrowing authority along with some face-saving items for the conservative wing of the party.

Rubin: "We were at the end."

Rubin had warned early in the standoff that even approaching default would roil financial markets, but they remained surprisingly untroubled throughout. "When I talked to people I knew, not at the time, but later, what people said to me was nobody ever really believed that the United States government would default on its debt," Rubin says. "But I tell you, we were worried about it."

At the time, Republicans speculated that Rubin had more tricks up his sleeve. Rubin says now that he didn't. "When we got to the end, we were at the end," he says. And he still doesn't know what President Clinton would have done if Republicans hadn't backed down and instead forced him to choose between their budget and default. "I've always wondered," he says.

In the years since, Treasury has expanded its toolkit for delaying a default if the federal government passes the debt ceiling. But none of the options buy as much time simply because the deficit is so much bigger. Heading into the debate, Republicans appear to have a stronger hand today than they did 15 years ago.

"I don't think people were as energized as they are today about the structural size of the deficit," Hawke says. And the public is highly skeptical about the need to lift the limit, with 63% opposing a hike in a recent CBS/ New York Times poll, and only 27% supporting one.

On the Hill, a much more concerted effort is already under way to sell the necessity of taking action. Business groups, led by the U.S. Chamber of Commerce, are lobbying lawmakers, with a focus on the House Republican's sizable freshmen class. Wall Street executives are weighing in, too, telling Republicans that a delay could wreak havoc on the markets.

Boehner, a student of Gingrich's overreach and its political consequences, has privately assured industry executives he understands the gravity of a default. The price of GOP support, however, will be steep spending cuts and structural reforms, as-yet unnamed.

A Republican operative and veteran of the last showdown says the party, now as then, wants to find a resolution. "It's about forcing the other side to negotiate toward a deadline, which is a good thing in a political system designed to avoid making decisions," he says. But as Rubin notes, in the intervening years, as our deficits ballooned, our system lost credibility on fiscal matters. "Now the world is looking at us, and we face these enormous deficits," he says, "and there's just a lot more concern about whether our system is going to deal effectively with all this."

Lessons from America's Last Brush with Default

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