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Lately, an American political debate over legal limits to the amount of US federal debt outstanding—the debt ceiling—is leading to many headlines on both sides of the Atlantic. These debates have happened relatively frequently in recent years, and as we have found to be normal, headlines speculate about possible financial Armageddon. In doing so, much of the commentary we have read seems quite confused what is—and isn’t—at issue. Here we will go through everything from the basics of the debt ceiling to the details as to why we think those financial Armageddon claims are a stretch, to put it mildly.
What is the debt ceiling, anyway?
The debt ceiling, or debt limit, as some call it, is the statutory limit on the amount of US federal debt the country can have at any given time. America’s Congress created it under the Second Liberty Bond Act of 1917, as the costs of World War I ratcheted higher. According to our review of history, before the debt ceiling, Congress had to pass legislation authorising the issuance of debt to fund spending any time it was necessary, which proved a bit unwieldy when war spending ramped up. So the legislation allowed the Treasury to manage government debt (called Treasurys) issuance so long as the total amount of debt outstanding was underneath the ceiling. Since then, the government has raised or suspended it over 110 times. Hence, the debt ceiling doesn’t actually limit debt in any understandable sense of the term, nor does raising it actually increase the debt. Congress makes those decisions, as we have found some politicians are fond of pointing out during debt ceiling debates, when it passes tax or spending legislation.
What happens when the amount outstanding nears the limit?
Well, a few things. As the limit draws near, the US Treasury Department usually slows and eventually ceases to increase the amount of Treasurys in circulation. This doesn’t, as we have seen some articles claim, mean no new debt can be issued. The government can still issue new debt to refinance maturing Treasurys—see the passage above—as this wouldn’t increase the amount of debt outstanding.
But since the US federal government routinely runs deficits (spending exceeds tax revenue), the Treasury generally needs to increase the amount of debt outstanding.[i] Now, the Treasury does often have cash on hand, and it can take actions slowing the spend rate—like temporarily suspending contributions to government employee pensions and such. These extraordinary measures, as the Treasury calls them—a great name for a rock ‘n roll band—are a way to temporarily keep the debt just below the limit. The Treasury is using them now, and it loosely expects its ability to do so will end sometime in October.[ii] The Bipartisan Policy Center, a Washington, D.C.-based think tank, somewhat more specifically says the Treasury’s ability to use extraordinary measures will end between October 15 and November 4.[iii]
At that juncture, if Congress still hasn’t raised or suspended the debt limit, it could have to cut spending back to levels funded by tax revenue. Spending and tax receipts vary from month to month, but in the 11 completed months in fiscal 2021, the US government averaged spending of $572 billion (£426 billion) and tax receipts of $326 billion (£243 billion) monthly.[iv] The government could have to suspend the difference until Congress lifts the debt limit.
So then the US government would automatically default?
No. Default is a specific term meaning failure to pay interest or principal due on Treasury securities. As noted early on, being at the debt ceiling doesn’t prevent the Treasury from refinancing maturing Treasurys, so principal isn’t at issue. As for interest, the government has paid an average of $47.7 billion (£35.3 billion) monthly in fiscal 2021.[v] Now, this is also lumpy. But in no month did interest payments come anywhere near topping tax receipts.[vi]
That is a very important fact. It means the US government would likely have the capacity to service the debt (plus quite a bit) even if Congress elected not to raise the debt ceiling (which we think is exceedingly unlikely to happen, as we will discuss shortly). If the US government services its debt, it is hard to see how claims of spiking interest rates and financial Armageddon hold water.
Still, in the past we saw some commentators and politicians suggest the government couldn’t pick and choose which bills to pay, meaning default risk remained. This is—and was—wrong, as former Treasury Secretary Jack Lew admitted in a 2014 letter.[vii] He said the New York Fed, which is responsible for servicing the debt, is “technically capable” of continuing to pay interest due on Treasurys whilst halting some other payments. Furthermore, the 14th Amendment of America’s Constitution contains a clause stating that, “… the validity of the public debt … shall not be questioned.”[viii] This language is a bit vague, but subsequent court rulings including the Supreme Court’s 1935 interpretation seemingly require the government to put Treasurys ahead of all other obligations, according to our historical research.
What about other spending?
Whilst the preceding factors make default exceedingly unlikely, that doesn’t mean other spending cuts wouldn’t hurt. They could, and prioritising payments would likely create winners and losers. Treasury officials could have to make some difficult choices until Congress lifts the debt ceiling.
But is this necessarily a huge enough negative to send equities reeling? In our view, no. There is precedent for the US government not paying some obligations: government shutdowns. During these periods, when the budget lapses and Congress hasn’t approved funding to keep non-essential departments open, some workers aren’t paid and many departments shut down. This isn’t a default; we have never seen anyone claim it is. It isn’t great for those affected, of course. But shutdowns haven’t historically made Treasury yields spike, and no government shutdown has ever triggered a bear market, according to our research (a bear market is typically a long, fundamentally driven equity market decline exceeding -20%). The last shutdown, history’s longest, ran from 22 December 2018 to 25 January 2019.[ix] America’s S&P 500 Index rose 10.4% in US dollars during this span.[x]
But didn’t the debt ceiling create trouble in 2011, when credit-ratings agency S&P downgraded America’s AAA credit rating?
It is a fair enough point that equity markets were volatile in August 2011, when a protracted, bitter debt ceiling debate motivated credit-rater Standard and Poor’s to downgrade the US government’s credit rating. However, it is worth considering the full picture. This fight came amidst a global correction (a short, sharp, sentiment-driven decline of -10% to -20%) that began months earlier.[xi] The S&P 500 hit its pre-correction high on 29 April.[xii] During this span, warnings that the eurozone debt crisis could shatter the common currency ran rampant, according to our review of financial publications. Whilst we don’t question the assertion that the downgrade spurred some short-term swings, the degree is unknowable, in our view. Moreover, there have been many other debt ceiling squabbles, like one in 2013, that did not accompany material equity market negativity.[xiii] Most coverage of the debt ceiling we have seen lately ignores that.
I read the 2011 downgrade cost the government $1.3 billion (£968 million) in extra interest. What say you?
We don’t think that is accurate. That figure is an estimate from America’s Government Accountability Office (GAO). But it doesn’t account for the fact Treasury yields fell after the downgrade.[xiv] The GAO’s estimate, however, operates on the difference between US Treasury yields and corporate debt yields (called credit or yield spreads). As it stated in the report, “A decrease in the yield spread indicates that the market perceives the risk of Treasury securities to be closer to that of private securities, increasing the cost to Treasury.”[xv]
Whilst spreads can be useful in judging many things, this methodology is questionable, in our view. For one, corporate yields rose and were elevated during the aforementioned equity market correction tied to both debt-ceiling theatrics and widespread warnings that European issues would ripple globally.[xvi] Their fall afterwards as those issues faded could easily have driven the results the GAO tallied, in our view. We think the absolute yield here is the better metric, and the decline in Treasury yields after the downgrade doesn’t appear to us to support the GAO’s conclusion.
OK. But still, this doesn’t seem like a very useful debate to have.
Agreed! We think the debt ceiling is about as useful as a whale’s hipbone. We very much think eliminating it would be ideal, although we aren’t in the policy advocacy business. We see many people argue that every time it comes up. But, alas, the debt ceiling likely isn’t going anywhere, and here is why: Politicians seem to love it, in our experience. Both parties have historically used it as a wedge. Republicans have seemingly done so more frequently of late, but that tradition crosses the aisle.[xvii]
Yes, yes, we know, politicians don’t act like they love it. But consider the current circumstances: The Democratic Party has the White House and a majority in the House and Senate (via tiebreaker vote cast by Vice President Kamala Harris). Congress can raise the debt ceiling via a process called budget reconciliation, meaning it requires only a simple majority in the House and Senate—not the 60 votes Senate rules often require to advance legislation. Hence, Democratic lawmakers could lift the limit with no Republican support. They don’t want to, because they think the Republicans would use it as a talking point in next year’s midterms, according to our review of politicians’ statements and associated coverage.
As for the Republicans, they could vote with Democratic politicians to raise the debt ceiling, but thus far they have declined to. We think they probably want to use this to help motivate their voter base ahead of next year’s legislative midterm elections. If they can force House and Senate Democrats to lift the debt ceiling unilaterally, they can claim still more increases tied to huge rafts of spending await, which may motivate some Republican voters to turn out next year. The whole debate is likely about political appearances before the midterms, in our view.
Those are the positions as they stand now. Normally, in our experience, the two sides reach a last second deal lifting the ceiling right before extraordinary measures elapse. This time? We aren’t convinced it will take that long. Again, there is no bipartisan compromise needed. Whilst the actual likelihood of default rounds to zero, in our view, House and Senate Democrats may see it as politically risky to allow a protracted debate over something members of their own party publicly said risks a calamity.
[i] Statement based on data from the White House Office for Management and Budget, which show the US government has run a deficit in every year since 2000 and in just 8 of 76 years since World War II.
[ii] Treasury Secretary Janet Yellen, Letter to House Speaker Nancy Pelosi, 8/9/2021.
[iii] “2021 Debt Limit Analysis,” Shai Akabas, Rachel Snyderman and Andrew Carothers, Bipartisan Policy Center, 24/9/2021.
[iv] Source: US Bureau of the Fiscal Service, as of 24/9/2021. Monthly Treasury Statement, August 2021.
[vii] “Treasury Says Debt Payments Could Be Prioritized in Default Scenario,” Tim Reid, Reuters, 9/5/2014.
[viii] Source: United States Congress, as of 30/9/2021. Full text of the 14th Amendment, Section 4.
[ix] “Government Shutdown: Trump Signs Bill to Temporarily Reopen Government,” Staff, Cox Media Group, 25/1/2019.
[x] Source: FactSet, as of 24/9/2021. S&P 500 total return in USD, 21/12/2018 – 25/1/2019. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[xi] Ibid. Statement refers to MSCI World Index returns in GBP with net dividends.
[xii] Ibid. Presented in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[xiii] See Note xii.
[xiv] Source: FactSet, as of 30/9/2021. US 10-year Treasury yield, 1/8/2011 – 31/12/2012.
[xv] “Debt Limit: Analysis of 2011 – 2012 Actions Taken and Effect of Delayed Increase on Borrowing Costs,” Staff, GAO, July 2012.
[xvi] Source: FactSet, as of 30/9/2021. Statement based on comparison of ICE BofA US Corporate Index yields and ICE BofA US Treasury Index yields, 31/12/2010 – 31/12/2012.
[xvii] “Congress and the Politics of Statutory Debt Limitation,” Linda K. Kowalcky and Lance T. LeLoup, Public Administration Review, January/February 1993. “Obama: 2006 Debt Ceiling Vote Was Politically Motivated,” Melanie Staley, Roll Call, 14/4/2011.
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