Why Interest Payments Come First

Originally published on July 29, 2011 4:07 pm

At some point next week, if Congress doesn't agree to raise the debt ceiling, the U.S. government may have to decide which bills to pay. What comes first: Social Security checks? Military spending? Food stamps?

There's not even a choice, says Jerome Powell, a former Under Secretary of the Treasury for Finance.

"Interest will be paid first," he says. "There's really no thought process there, it just has to be that way."

Why pay interest on U.S. government bonds before paying for, say, food stamps?

"If we start defaulting on our debt there are going to be a whole lot more people on food stamps than there are now," Powell says.

That's because government debt is essential to the plumbing of the economy. People and companies treat investments backed by Treasury bills almost like cash — and they expect T-bills to be as reliable as cash.

"Treasury bills are the only financial instrument in the world where anyone can invest in them and believe there is literally no risk of not being paid back," Powell says.

Mark Peterson is the treasurer of ServiceMaster, a company based in Memphis, Tennessee. They do lawn care, among other things. He relies on investments backed by T-bills to pay his employees.

"In our TruGreen lawn business, the season is summer," he says. "So in the middle of June and July, we're applying a lot more applications of our fertilizers and pesticides on people's lawns. We then bill the customers, and the customers' payments come in later."

No problem-- Peterson just taps the company's investments, and pays his employees with that money. When the payments come in, he reinvests it in T-bills

If you don't pay back your creditors, then you're no longer the least-risky investment in the world. People will buy other bonds, that look safer. And it will become more expensive for the government to borrow money.

It turns out that in fiscal crises, interest on bond payments gets VIP treatment again and again.

In New York's financial crisis in the mid-1970s, the city put interest payments on bonds first — even in front of sanitation workers, which upset the sanitation workers union.

"They let the garbage pile up on the streets of New York," says Donald Kummerfield, former budget director of New York City. "The city was ... stinking."

And just a few weeks ago, when Minnesota's state government had its own crisis, the state passed a law that said payments on bonds came before everything else.

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MARY LOUISE KELLY, Host:

OK. Let's look at what will happen if Congress fails to raise the debt ceiling and the U.S. Treasury has to decide which bills to ignore and which to pay. NPR's Zoe Chace of our Planet Money team says interest on bonds will likely come first.

ZOE CHACE: You don't even have to think twice about what to pay first. It's not even really a choice.

JEROME POWELL: First of all, interest payments will always be made first. And three's really no thought process there. It just has to be that way.

CHACE: Former undersecretary of the Treasury Jerome Powell says interest on government bonds comes first, even if you skip something like food stamps. Why?

POWELL: The answer to that question is that if we start defaulting on our debt there are going to be a whole lot more people on food stamps than there are now.

CHACE: For example, I sat down with two of the white knights that pulled New York City out of bankruptcy in 1975.

DONALD CUMMERFIELD: I remember Manhattan Community College downtown was half built and I gave the order to stop. Send all the construction workers home, board it up; we will finish it after the fiscal crisis.

CHACE: And when did you guys meet become friends?

RICHARD RAVITCH: Nineteen seventy-six.

CUMMERFIELD: Seventy-five.

(SOUNDBITE OF LAUGHTER)

CHACE: In 1975, the city defaulted on some of its payments. In order to continue to do business, they had to cut deep. But they still put interest payments on bonds first. Even in front of sanitation workers, which upset the sanitation workers union.

CUMMERFIELD: They let the garbage pile up on the streets of New York when they were on strike. Eventually we settled it and they came back and picked it up but the city was pretty stinking.

CHACE: Richard Ravitch says they wanted to defer the interest payments on the city's loans, and it went all the way to the highest court in the state. Mr. RAVITCH: We did pass a law deferring the payment of interest on debt. But the court ultimately said that that law was unconstitutional, that the state had to use its inherent taxing power to meet its obligations.

CHACE: Here's Cummerfield.

CUMMERFIELD: The State of Minnesota is a good example. Recently they ran out of money. But before they did that, they passed a law saying the first revenues that the State of Minnesota has will be to pay debt service on our bonds. And after that we will pay, you know, go down the line - we close parks, we close this...

CHACE: Why do we make interest on bonds the top priority, the first payment? Ask a former Treasury official, and he'll say...

POWELL: Treasury bills are the only financial instrument in the world where anyone can invest in them and believe that there is literally no risk of not being paid back.

CHACE: Like in our TruGreen lawn business, the season is the summer. So in the middle of June and July, we're applying a lot more applications of our fertilizer and pesticides on people's lawns. We then bill the customers and the customers' payments come in later.

CHACE: Zoe Chace, NPR News, New York.

LOUISE KELLY: You're listening to MORNING EDITION from NPR News. Transcript provided by NPR, Copyright NPR.