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Predictably, as time passes without legislation to lift it, angst over the US debt ceiling seems to be growing. As normal, headlines speculate about possible “financial Armageddon” and, frankly, many articles in the financial press seem downright confused about the whole shebang. 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. Congress created it under the Second Liberty Bond Act of 1917, as the costs of World War I ratcheted higher. You see, before the debt ceiling, Congress had to pass legislation authorizing the issuance of debt to fund spending any time it was necessary. That was a bit unwieldy when war spending ramped up. So the legislation allowed the Treasury to manage bond issuance so long as the total amount of debt outstanding was underneath an arbitrary figure Congress conjured up—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 some politicians are fond of pointing out during debt ceiling fights, when it passes tax or spending legislation.
What happens when we get near the limit?
Well, a few things. As the limit draws near, the Treasury slows and eventually ceases to increase the amount of bonds in circulation. This doesn’t, as some articles claim, mean the Treasury can issue no new debt. It can still issue new debt to refinance maturing bonds—see the passage above—as this wouldn’t increase the amount of debt outstanding.
But since the federal government routinely runs deficits (spending exceeds tax revenue), the Treasury generally needs to increase the amount of debt outstanding. This is basic government finance. 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”—a great name for a rock ‘n roll band—are a way to temporarily keep debt just below the limit. The Treasury is using them now. But these are rather limited, and the Treasury loosely expects its ability to do so will end sometime in October.[i] The Bipartisan Policy Center, a Washington-based think tank, somewhat more specifically says the Treasury’s ability to use extraordinary measures will end between October 15 and November 4.[ii]
At this juncture, if Congress still hasn’t raised or suspended the debt limit, it would 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 government averaged spending of $572 billion and tax receipts of $326 billion monthly.[iii] The government would have to suspend the difference until Congress lifts the debt limit.
So then we default?
No. Default is a specific term meaning failure to pay interest or principal due on Treasury bonds. As noted early on, being at the debt ceiling doesn’t prevent the Treasury from refinancing maturing bonds, so principal isn’t at issue. As for interest, the government has paid an average of $47.7 billion monthly in fiscal 2021.[iv] Now, this is also lumpy. But in no month did interest payments come anywhere near topping tax receipts. We showed you this recently.
That is a very important fact. It means the 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 is exceedingly unlikely to happen, as we will discuss shortly). If the government services its debt, it is hard to see how claims of spiking interest rates and “financial Armageddon” hold water.
Now, in the past some suggested the government couldn’t pick and choose what bills to pay, meaning default risk remained. This is—and was—wrong, as former Treasury Secretary Jack Lew admitted in a 2014 letter.[v] He said the New York Fed, which is responsible for servicing the debt, is “technically capable” of continuing to pay while halting other payments. Further, the Supreme Court’s interpretation of the 14th Amendment’s public debt clause requires the government to put Treasury bonds ahead of all other obligations.
What about the government’s other obligations?
While default is off the table, that doesn’t mean other spending cuts wouldn’t bite. They could, and prioritizing payments would undoubtedly create winners and losers. Now, many articles highlight the military, veterans and Social Security recipients going unpaid. But those three categories plus debt interest average $226 billion a month this fiscal year to date—well below average tax receipts.[vi] Now, again, the government’s budget isn’t smooth—receipts were a hair below that in two months this year. But this does speak to the fact cuts wouldn’t automatically come from these areas.
Actually, we have some precedent for the government not paying some obligations, too: Government shutdowns. During these periods, non-essential workers aren’t paid and many departments shut down. This isn’t a default. No one claims it is. It isn’t great for those affected, of course. But it hasn’t historically made Treasury yields spike, and no government shutdown has ever triggered a bear market. The last one, history’s longest, ran from December 22, 2018 to January 25, 2019.[vii] The S&P 500 rose 10.4% during this span.[viii]
But didn’t the debt ceiling create trouble in 2011, when S&P downgraded America’s AAA credit rating?
Fair point, 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 remembering the full picture. This fight came amid a global correction that began months earlier. The S&P 500 hit its pre-correction high on April 29. During this span, fears of the European debt crisis shattering the euro ran rampant. While we don’t question the fact the downgrade spurred some short-term swings, the degree is unknowable. Moreover, there have been loads of other squabbles, like 2013’s, that saw little to no fallout. Most coverage of the debt ceiling lately ignores that.
I read the 2011 downgrade cost the government $1.3 billion in extra interest. What say you?
No. That figure is an estimate from the Government Accountability Office (GAO), but is a stretch, in our view. For one, Treasury yields fell after the downgrade. The GAO’s estimate disregards that and operates on the difference between US Treasurys and corporate debt (credit or yield spread). 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.”[ix]
While spreads can be useful in judging many things, using them for this purpose is highly questionable, in our view. For one, corporate yields were elevated during the aforementioned equity market correction tied to fears of European issues going global. Their fall afterwards as those fears faded could easily have driven the results the GAO tallied. In our view, the absolute yield here is the better metric, and it doesn’t support the GAO’s conclusion.
OK. But still, this doesn’t seem like a very useful debate to have.
Agreed! 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. Loads of people argue that every time it comes up. But, alas, the debt ceiling likely isn’t going anywhere, and here is why: Politicians love it. Both parties have historically used it as a wedge. Republicans have seemingly done so more frequently of late, but that tradition crosses the aisle.[x]
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). Congress can raise the debt ceiling via budget reconciliation, meaning it requires only a simple majority in the Senate and not 60 votes. Hence, the Democrats could lift the limit with no Republican support. They don’t want to, presumably because they think the GOP would use it as a talking point in next year’s midterms.
As for the GOP, they could participate, but they probably want to motivate their base ahead of next year’s midterms. If they can force House and Senate Democrats to lift the debt ceiling unilaterally, they can use this as a talking point to claim still more increases tied to huge rafts of spending await. The whole debate is about political appearances before the midterms, in our view.
Those are the positions as they stand now. Normally, the two sides reach a last second deal lifting the ceiling right before extraordinary measures elapse. This time? We aren’t so sure it takes that long. Again, there is no bipartisan compromise needed. While the actual likelihood of default rounds to zero, in our view, House and Senate Democrats have employed rhetoric arguing the opposite. They may see it as a risky political stance to allow a protracted debate on it as a result.
[i] Treasury Secretary Janet Yellen, Letter to House Speaker Nancy Pelosi, 9/8/2021.
[ii] “2021 Debt Limit Analysis,” Shai Akabas, Rachel Snyderman and Andrew Carothers, Bipartisan Policy Center, 9/24/2021.
[iii] Source: US Bureau of the Fiscal Service, as of 9/24/2021. Monthly Treasury Statement, August 2021.
[v] “Treasury Says Debt Payments Could Be Prioritized in Default Scenario,” Tim Reid, Reuters, 5/9/2014.
[vi] See note iii.
[vii] “Government Shutdown: Trump Signs Bill to Temporarily Reopen Government,” Staff, Cox Media Group, 1/25/2019.
[viii] Source: FactSet, as of 9/24/2021. S&P 500 total return, 12/21/2018 – 1/25/2019.
[ix] “Debt Limit: Analysis of 2011 – 2012 Actions Taken and Effect of Delayed Increase on Borrowing Costs,” Staff, GAO, July 2012.
[x] “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, 4/14/2011.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.