Mitu Gulati on Whether Trump Could Restructure US Debt

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1:15Bloomberg Audio Studios. Podcasts. Radio. News.

1:30Hello and welcome to another episode of the Odd Thoughts podcast. I'm Traci Allaway. And I'm Joe Weisenthal. Joe, you know what I like to say about bonds? Go on. I think there's this perception that bonds are all about finance and legalities. They are these contracts. And borrowers have to stick to the contract. Lenders have to stick to the contract. But actually, I like to look at bonds as more stories. And I know we've been talking on this podcast a lot about norms and the idea that a lot of the way the U.S. operates is based on norms and habits that have developed over time. Bonds are kind of the same way.

2:13It's all about the narrative of who owes whom what and why. and that can change really quickly. You know, it's actually interesting about you saying this. I was thinking back to our episode that we did with Sujit Indap about creditor-uncreditor violence. And perhaps one way to think about that whole phenomenon is the exploitation of rules above norms, right? So you have all of these norms about how debt is paid back, et cetera, and there's like extra alpha to be squeezed by actually redoubting to the courts and the rules that are literally written down in a fight between creditors about who gets the cash flows, etc.

2:56And it really is about this tension of like, what's written on paper? What's technical? What does these words mean, etc. versus, come on, that's not how we deal with bonds. That's right. You can use the rules if you're really clever to try to achieve your aims, right, and change the story on some of these bonds. So we should talk about that because there is a lot of discussion about what the Trump administration could do when it comes to sovereign debt. Obviously, people have been talking about the potential Mar-a-Lago Accord, which includes a possible debt swap. Again, all of that is hypothetical at the moment.

3:31But beyond that, there are some other things going on. And it certainly seems like nothing is off the table when it comes to the Trump administration. So we should discuss. Yeah, but can I just say one thing, which is my ethical reservations here of doing any episode? It feels like the entire world now operates in this system in which people both outside of the White House and inside the White House, the various people trying to like curry Trump's favor on a given day, try to wish cast their ideas about policy into the ether. And they put out a tweet and they say it's a negotiation. They say it's not a negotiation.

4:07They say there should be a pause, et cetera. And there is this incredible maelstrom of noise where it's all about trying to manifest some outcome that so-and-so person desires. And I have some ethical questions about this sort of contribution to the noise by introducing the idea of, like, further taking seriously the idea of debt swaps, which to me sounds like default into the world. But, yes, this is one thing that in this great manifestation of ideas people are talking about. So I suppose we should talk about it. You always say you want to take Trump literally and seriously. I only take him literally anymore.

4:42Okay, here's our disclaimer. This is not an actual policy suggestion for the Trump administration, but we are going to talk about it. People are talking about it, so let's talk about it. How realistic it is. And we have the perfect guest. We're going to be speaking with Mitu Galati, law professor over at the University of Virginia, and one of our favorites when it comes to all the ins and outs, the technicalities, the legalities of sovereign debt. So, Mitu, thank you so much for coming on All Thoughts. I'm so excited to be here. I shouldn't be excited about all the crazy loony things that are being discussed.

5:15But from an academic perspective, this is just heavenly, even though I might be jobless soon. Right. So markets have been crazy, but the upside is, I guess we get to talk about bond contracts. When did you first become aware of the Mar-a-Lago Accord? When did people start talking about it? So I actually think that I heard about it on one of your podcasts. Oh, God. About the Mar-a-Lago Accord. It's all our fault. And then I dug into it and looked at one of the proposals in particular interested me, which was sort of swapping out short-term U.S. Treasuries for longer-term, low-interest U.S. Treasuries, which was talked a lot about as a debt swap with our allies, but really was just an extension of maturities at a low rate when the market might not actually be giving you the low rate.

6:19And that has become, I mean, that was, I think, implausible when you guys talked about it. It was just sort of, oh, here's some crazy ideas. People are now emailing and asking sort of respected market people, how could this happen? And what would the legal barriers be? And what are the ramifications? So what's basically going on in the last several weeks is that this very theoretical idea, which, by the way, Trump himself actually, I don't think he's ever used. He certainly never used the term Mar-a-Lago Accord. But there's the people around him, some influential thinkers talking about this could be some endgame here where there's some sort of rethinking about the U.S.

7:01dollar and the debt. And now it's come to the point where people who are serious in markets, they're coming to you, Me Too Gulati, and they say, what's up? Help me understand this. Yes. And I think so. You know, we talked about Trump and taking him seriously and taking the kinds of things that he has done in the past seriously and what he's willing to do. And restructuring distressed debt is something that he has done a lot of. And he talked about it prior to his first presidency when he talked about, oh, the U.S. debt, not a big deal. We could just inflate it away or something like that. A debt swap using the power of U.S.

7:49governing law is really not that insane, both in historical context and in what we could do. It is insane in terms of norms that have been built carefully over the last 60, 70 years. But Trump is not Alexander Hamilton, I think. Yes, to put it mildly. Explain this further. You said earlier a debt swap could be basically the equivalent of extending maturities on existing treasuries. But like, I would hope that there is some clause in the bond documents that would rule that out. Am I wrong? I guess I'm wrong. Alas, you are wrong. So anybody and everybody who holds U.S. Treasuries should go and look at the contract terms for their U.S.

8:44Treasuries and ask the question, Do my contract terms restrict the U.S. Treasury Department from saying to me tomorrow, you know, we need a little more money, so we're just extending the maturity of your debt by another 20 years at the interest rate that you lent to us. Is there anything restricting that? I don't think you'll find anything. Really? This blows my mind. Because to me, if I'm a holder of U.S. treasuries and the creditor or lender, the creditor says, you know what, I'm just paying you back a long time. To me, that sounds like default. And you're saying that in the research that you've done, this would not, say, trigger credit defaults off.

9:30Because to my mind, my assumption would be, oh, this breaks the entire system. This is a default. And we can't have a default on the risk-free assets. And you're saying that actually in the wording of the document, it's not there. So we have to be clear and I have to be geeky here in my law professor mode. There are at least three different types of default. So there's a default on the contract, something you could sue somebody for, breach of contract. It would not be a breach of contract. U.S. government is allowed to do this. Then there's default in terms of would it trigger the handful of credit default swaps that are written on U.S.

10:09Treasury. Well, that sort of depends on what the credit rating agencies decide. And based on what we saw in Greece 2012, they probably would say it was a default for credit default swaps. But that doesn't apply to everyone. So those are the two big default scenarios. What do you mean that doesn't apply to everyone? Well, they don't. the default for a credit default swap really only applies to the people who are holding credit defaults protection on US Treasury. So they would be able to get their money back from somebody who had provided them insurance. But the rest of us dupes like me would just have to sit with the US extending the maturities.

10:56Now, the details are important. But if you are willing to let me bore you with them, I can sort of sketch out the scenario. Always, always. Okay. My students asked me this in class a couple of days ago, so I had to sketch it out for them. So I said, step one, the U.S. Treasury Department and the Secretary of the Treasury have authority to manage the maturities of U.S. Treasuries. What does manage the maturities mean? It really does mean issuing bonds of different maturities, managing your yield curve. But could it include unilaterally extending the maturities? Seems implausible, but this government has pushed its legal authority in many ways.

11:49Now, what is most likely to happen that the U.S. Treasury, if they ever went down this path because, say, they needed money and rates had gone up and they wanted to take advantage of the fact that their old borrowing was at low rates, what they would do, I think, the pattern we have seen, is that they would extend the maturities and then Congress would quickly pass a law confirming it. That's what we've seen in all of the other Trump executive orders plus Congress quickly passing a law. And then there would be lawsuits. There would be lawsuits left and right saying this is a violation of the Constitution.

12:33Because remember, there's no contractual protection. So now you have to say, you've somehow taken my property and I have an implicit moralistic right to having my money paid back at the time when you said you had paid back. Now, that's really tough. And we have historical precedent for this going back to the 1930s when we were in deep trouble because of gold. We didn't have enough gold to pay everyone in case they invoked their gold clauses, which entitled holders of certain U.S. treasuries to get paid in gold. If they had gotten paid in gold or asked to get paid in gold, U.S. would have essentially gone broke.

13:24So the president, backed by Congress, abrogated the gold clause protection in contracts. And it was thought that surely the Supreme Court would say, this is not allowed. You cannot just take away people's contractual rights. and the Supreme Court in one of the most famous cases of that era said it was okay. And the markets, I don't want to say this, but I'm going to say it because it's true. The markets didn't crash. Yeah. What year was this? I think it's around 1935. I'm going to mess up which year Congress did the abrogation and then when the Supreme Court decision came out. But the predictions were this will destroy the U.S.

14:12ability to ever borrow in the future. And that did not happen. There are some famous articles about this.

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15:21All while consolidating your corporate food spend so you can control costs, streamline billing and payment, and simplify reporting. EasyCater, your business tool for food. To learn more, visit easycater.com slash podcast. What's your read then on why this didn't happen? Like, why did the market seem to just go like, okay, this is unusual, but fine? So my read with no proof is that there are these rare instances where the market thinks, You know, this abrogation of contractual rights, while it looks like a violation of the rule of law in every which way possible, is necessary to make us all better.

16:10And therefore, instead of penalizing the government that does it, we're going to reward them and we're going to lend even more. Arguably, Greece in 2012, where Greece also legislatively abrogated contractual rights and did something very similar, is a similar situation where the market didn't penalize them anywhere near the amount that many sages on Wall Street were saying would happen. Now, I'm not saying that that's what would happen now. I mean, this administration seems crazy. What about 14th Amendment Section 4 that says the validity of the public debt of the United States authorized by law, including debts incurred for payments of pensions and bounties for services and suppressing insurrection or rebellion should not be questioned?

17:06Oh, I love it that you're bringing up the 14th Amendment and the debt language of the 14th Amendment that my students don't even know exists. The only reason I know about this is because it comes up a lot during the debt ceiling crisis. Joe carries around a copy of it in his pocket at all times. Okay, this language is so important for a variety of reasons relating to multiple debt crises around the world, but I won't go into those. Let's just look at the language about the validity of the U.S. debt. arguably, that language goes back to the 1800s at least, when often small municipalities would say a certain debt was illegally issued by this government in place that did not have the proper authorization to issue it.

17:59So if that's the meaning of validity, that it's about the original issuance, the Trump administration could say, we're not challenging the validity. We think your debt is very valid. We're just extending the maturity. And we do promise to pay you. Let's say they extend the maturity by 100 years. We promise to pay you in 100 years. When we're all dead. Yes. Okay. I hesitate to ask this question for some of the reasons that Joe laid out earlier, But we've established that there's a lot of creativity embedded in the rules of bonds, or at least you can use those rules rather creatively to achieve whatever aims you're trying to achieve.

18:44One of the things that has come up recently is the idea of maybe collecting on historical debt that was never paid to the U.S. You know, I called it the equivalent of like looking in your sofa under the cushions for a spare change. How viable would something like that be? Okay, legally, that is much more viable. So this has come up in the context of there's a recent book, very recent by a senior U.S. Treasury official about the negotiations between Andrew Mellon and Winston Churchill about the debts that were owed to the United States by Great Britain after World War I. So I think it's about$4.4 billion or so that was owed.

19:35And Great Britain resisted paying, and the U.S. tried to get it paid. And then finally, we kind of gave up, and then we had World War II and all sorts of things. Those debts have never been written off officially. They are still official debts of now the United Kingdom to the U.S. They had interest rates on them. I think the interest rate was 3%. If you compounded that amount to today's values, that would be many trillions of dollars worth. Okay, so that's old. But how would you engineer this? That's a debt that is owed by the United Kingdom to the U.S. The U.S. owes the United Kingdom because the United Kingdom, by the Treasury's own estimates, holds upwards of 700 billion in U.S.

20:31treasuries. Those can be, and the legal term is, set off. Two sets of debts can be set off against each other. It is a technique that is used every day in the markets. It's just, who would have thought that it could be applied in this context? But it can be. And in fact, in the Russia-Ukraine context, the Biden administration thought very hard about using set-off techniques to get funding to Ukraine. So this is an idea that's out there, current, but applying it to the UK debt and then maybe even applying it to the French debt from World War I would be truly radical. But maybe it wouldn't destroy the markets in the same way as the first swap that we discussed.

21:24That's a very big maybe. But OK, so theoretically, the U.K. debt could cancel out some U.S. debt. I think this is a really good example of where norms come into play, because, OK, after World War I, the U.S. knew that the U.K. owed it a bunch of money. but the UK was arguing, well, this is actually emergency war funding and it's not fair if we have to pay it back. And ultimately, the US just decided, you know what, it was better to keep the UK as an ally, not annoy them over this particular loan. And so they just never did anything about it. But obviously, relations between the US and the UK are changing, not as friendly as they used to be, perhaps.

22:12And so that opens up the question of whether the values around these loans and bonds can start to change. No, well, this sort of anticipated the question that I was going to go to, which is like, say more about like why it was just accepted that these debts were not collected upon. Well, I'm not sure. There is extensive writing about the negotiations. I think they went all the way up to the 1970s. And for those who study financial history, post-World War II was a truly horrible time in Europe. The U.S. was trying to help European countries recover. The U.K. in particular had taken the position after World War I that the U.S.

23:01should try to collect this money from Germany. because really Germany owed the money to the UK and France in reparations. And sort of the consensus was World War I reparations were a stupid idea and resulted in World War II. This is Keynes and all of that work. But generally, in the interest of letting Europe recover, I think the U.S. decided better not to push this. But Congress never allowed those debts to be wiped out completely. And so in some sense, this has always been an option. I have heard Treasury officials, people negotiating debt restructurings talk. And every once in a while when they can't get the UK to do what they want, US officials will kind of snidely mention, you know, there's that World War I death that you never paid.

24:04And everybody laughs and in a knowing way. And then I have this image of them having like a laminated copy of the bond documents and just whipping it out in negotiation. But actually, that reminds me, we don't know what the exact bond documentation is. We don't know. We don't even know. I mean, we know the interest rate is 3%. I've never met anybody who's actually seen the document. Back in 1917, I don't think it would have been governed by the law of New York or the law of England. So who knows what statuta limitations would be? Who knows today whether or not there is some kind of international statutor limitations that would apply?

24:46And would it apply in the context of set-off? This is just, for lawyers, this is a bonanza. We could be working on this forever. But it seems a bit crazy, but nothing is crazy these days. The lawyers always win. So speaking of all these old debts and world wars and stuff like this, I've gotten into my, I'm in my mid-40s. So, of course, I read about 20th century history now. And one of the things that actually like was like this big like light bulb revelation for me in reading history is that like modern fixed borders of countries. It's sort of a novel phenomenon that actually like the idea that like these are the lines around the country.

25:29We just all sort of accept that is like very fresh in modern history. And what was striking is like reading about the run up to World War II, like the Germans would sign a border agreement with another country, but it would be only 10 years. They're like, let's be peaceful for 10 years and then we'll revisit war down the line. And we'll decide whether or not to be enemies. And then we might revisit the idea of conquest. But at least in the meantime, some of it's coming back and it's coming back, particularly with respect to Trump's talk about Greenland. And people talked about how much a lot of people think it's a joke.

26:01But a lot of people have gotten burned by thinking that things Trump has been saying are a joke. And so that's why I've become much more on the take Trump literally side. How should we think about the idea of like countries just sort of like acquiring land from other countries as a thing that could happen in the 21st century? OK, this is going to happen. It's not could happen. You're raising an incredibly important question. So there is Greenland. But Greenland's kind of fun to talk about. Yeah. Although, you know, Trump seems very serious about it. He keeps telling us, don't think this is a joke.

26:36We have to have it and I will have it. But it's going to be directly relevant in the context of Ukraine. So let us say that Mr. Putin is able to negotiate with President Trump to take half of Ukraine. Okay. So Ukraine becomes baby Ukraine. what happens to the enormous pile of debt that Ukraine has that is unpaid and that was restructured in the context of war, including billions and billions of dollars that are owed to the U.S. and to European allies? Does old Ukraine pay all of this? Or does baby Ukraine pay all of this? Does it get divided? It turns out that the laws from the era of conquest, those are the laws that apply even today of what happens when the borders of a state change.

27:37Those laws are really unclear. And so we'd have to decide in the modern era, how would those old laws apply, given that we pretend that borders don't change and we pretend that conquest is not allowed? I mean, Putin takes the position that what's happening in Ukraine is an independence movement that started domestically and that he's just encouraging it. Well, there is a whole set of laws that apply to civil wars. And if they take the position of this is a civil war, then there is 19th century debt law that applies to a civil war.

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