The Debt Ceiling Crisis: What Congress’ Negotiations Could Mean for the Market
Just three years after one of the worst economic downturns in a generation, a new Republican majority in the U.S. House of Representatives, extolling the need for fiscal austerity, faces down an unpopular Democrat in the White House and threatens a showdown over the debt ceiling. Is this 2011 or 2023?
About a month ago, Secretary of the Treasury, Janet Yellen, penned a letter addressed to the newly elected Speaker of the House, Kevin McCarthy, stating that the U.S. Treasury has reached its statutory debt limit of $31.4 trillion, and in turn, that the Treasury would begin taking extraordinary steps to allow the U.S. to continue servicing its debt and other mandatory spending. Immediately, public debate began about the implications of breaching the limit, the likelihood of sparking a debt ceiling crisis and subsequent economic calamity, and what steps should be taken to avert a catastrophe.
So what exactly is the debt ceiling, where did it come from, and what are the actual implications of the limit being reached for markets specifically, and the economy overall?
Under the U.S. Constitution, Congress has the sole authority to borrow money on behalf of the United States. From its founding to 1917, Congress authorized each individual bond issuance by the Treasury. However, as the size of the federal government grew, the process of approving each bond offering became onerous, particularly once the U.S. entered WWI and needed to finance a substantial increase in defense spending. As a result, Congress passed the Second Liberty Bond Act which established a limit on the total amount of debt the U.S. government could take on and alleviated Congress of the burden of daily votes for each new war bond issued.
The debt limit as it currently stands is largely a similar tool, and governed by the Public Debt Acts of 1939 and 1941, passed to provide further flexibility in financing the U.S.’ war effort during WWII, and these laws have since been amended repeatedly to increase that limit, by both parties. Historically, both parties have also used the debt ceiling as a political tool to attack the other side. Since the beginning of the War on Terror, the debt ceiling has grown at an exponential rate, especially after the enormous economic stimulus packages passed in the wake of the Global Financial Crisis and now the COVID-19 Pandemic. But as lawmakers battle again over whether and how to raise the debt ceiling, what exactly are they arguing about?
U.S. Hits Debt Ceiling; Extraordinary Measures Kick In
Source: Reuters, Jan 2023, Explainer: A looming U.S. debt ceiling fight is starting to worry investors
Contrary to popular belief, the debt ceiling does not authorize new spending or increase the amount of money the United States owes. Instead, the limit only affects the government’s ability to pay what it already owes. The size of the U.S. debt is the sum of its annual deficits between the amount the U.S. spends, and the amount it receives in revenue. Congress passes several laws throughout each session that authorize continued or generate new spending, and the same is true for tax legislation as well. Because government spending is almost always forward-looking, with spending often authorized ten or more years in advance, the debt ceiling is a limit on paying for previous tax and spending decisions lawmakers have already legislated.
Budget by Fiscal Year
The U.S. has run annual deficits for most of its history—it incurred $75 million in debt from the Revolutionary War—and it hasn’t paid down all of its debt since 1835. The last time the nation brought in more money than it spent was 2001.
Note: Not seasonally adjusted. Data after 2021 are projections. Source: Office of Management and Budget
Source: WSJ, Feb 2023, U.S. Could Default as Soon as July if Debt-Ceiling Standoff Isn’t Resolved
Once the U.S. Treasury hits the limit, it can no longer issue new debt to finance all spending previously legislated by Congress. The Treasury, however, is constitutionally mandated to achieve three things: to spend the money Congress has legislated; to tax people and businesses as dictated by Congress; and to issue as much debt as Congress authorizes. Therefore, when the debt ceiling is breached, the Treasury is stuck making a choice between which of these mandates it will violate.
When the Treasury has hit the debt limit in the past, it has taken so-called “extraordinary measures” to continue funding government spending, for example, skipping out on contributions to the Social Security Trust Fund, funding future pension obligations, and other technical maneuvers to free up cash. Once these extraordinary measures are exhausted, the Treasury runs out of money it can spend on anything. Because the law is unclear about which obligations are senior to one another (servicing its debt, Social Security or Medicare spending, tax refunds, etc.), a debt ceiling crisis looms when the limit is breached, with constitutional, economic, and political questions about what spending needs to be cut or suspended, without any obvious answers or even precedent to guide us.
Such extraordinary measures can only stave off a fiscal crisis for so long though. The Congressional Budget Office, a nonpartisan agency that provides budget and economic information and forecasts for Congress, estimates that such measures will buy the federal government a few more months, with available funds potentially exhausted as soon as July of this year, or as late as September, depending on the economy’s performance and subsequent tax collections. Congress therefore has as few as five months to come to an agreement. Once the money runs out, the federal government will have to decide which of its financial obligations to default on, and to weigh which will have the least calamitous impact on the global economy, the U.S.’ financial reputation, and everyday Americans’ lives.
Political battles over the debt ceiling stretch back to the 1950s, with both Republicans and Democrats aiming to score points by pointing to votes to raise the limit by the other party as evidence of their fiscal irresponsibility. However, in more recent years, the political brinksmanship of these fights has escalated dramatically, most alarmingly in 2011.
Back then, similar to today, a Republican-controlled House faced down a Democratic President and Senate, using the debt ceiling as leverage in an attempt to force lower spending by the US Government. While the mechanics of the ultimate agreement are too complex to lay out here, in short, after a very public, several months-long debate between the two sides, ultimately the resolution agreed to include a raise of the ceiling, freeing up the Treasury to meet the U.S.’ obligations, in exchange for a program of “sequestration”, or across the board cuts to all discretionary spending (e.g., defense, infrastructure, wages, but not payments on debt, Social Security, Medicare, Medicaid, and other “entitlements”).
In 2011, as the deadline to come up with a deal approached, the effects on the markets were unequivocal: a financial calamity that would far surpass the 2008 crisis was quickly priced in, across asset classes. The stock market plummeted, repo funding markets became severely dislocated, and the US AAA credit rating was downgraded by S&P for the first time in its history.
Debt Ceiling Crisis in 2011
Sources: Business Insider, Yahoo Finance
As the current debt ceiling crisis fast approaches, there are a number of different outcomes that could arrive. Congress could come up with an agreement and avert a catastrophe well ahead of schedule. While it is difficult to predict how backroom political deals will play out, given the smaller Republican majority in the House (compared to 2011), a more conservative Republican caucus, and the recent political showdown over the Speakership, negotiations may be more contentious than twelve years ago, which could spell further economic trouble. On the other hand, with the potential political fallout for Republicans of another manufactured economic crisis, Speaker Kevin McCarthy may be incentivized to come up with a deal with the Democrats before the crisis fully unfolds.
However, barring an agreement in Congress, there are generally no good options available to circumvent a catastrophe, certainly none that have been tried before, or that are without any clear negative ramifications. While there are many actions President Biden and the Treasury could take, they essentially boil down to either a) defaulting on U.S. debt and enacting massive spending cuts or b) nullifying or ignoring the debt limit.
As a result of its significance as a risk-free benchmark, as well as the deep integration between the U.S. and the global economy, defaulting on U.S. debt payments would have massive implications across global markets and national economies, impacting nearly every corner of the financial world. But in much the same way, massive spending cuts to get the government into surplus would have severe ramifications for the U.S. economy. As previously mentioned, there is no clear seniority between the various obligations of the federal government: are Social Security payments senior to servicing our debt? Could the United States legally forgo servicing debt held internally? These are all questions without answers that would inevitably lead to long and costly litigation, and in turn paralyze the operation of the federal government and markets.
At the same time, there are several options to effectively eliminate the debt limit. Some of the more popular suggestions include novel approaches, each with their own negative implications. First, under an obscure 1997 law designed to give the U.S. Mint power to mint platinum coins in various denominations, the way the law was written gives the Mint the power to create, say, a single coin of any dollar amount – which means in theory, a platinum coin with a, say $5 trillion face value, could be printed and deposited into the Treasury’s account at the Fed. Alternatively, some constitutional scholars argue that under the 14th Amendment, which states “the validity of the public debt… shall not be questioned”, interpreted as meaning that it is unconstitutional for the U.S. to default on its debt. In other words, the U.S. would be forced to pay its debt under the 14th Amendment, even if this would result in spending that would exceed the limit set through the debt ceiling law. Such an interpretation, however, would likely need to be resolved by the United States Supreme Court if it ever reaches that point. Finally, the Treasury could use the same tool many state and municipal governments have used to circumvent their debt limits: creation of a special purpose vehicle to issue debt that is practically, but not legally, separate from the Treasury’s debt. However, each of these options presents the possibility that a future President could abuse this power to issue unlimited debt, which investors may view as significantly increasing the likelihood of either hyperinflation, or a future default on debt.
As we get closer to the date the U.S. runs out of money today, without a political compromise, we may be able to expect similar market reactions to the debt ceiling crisis in 2011. Unsurprisingly given the ramifications, as the U.S. approached the date it would run out of money in 2011, volatility spiked precipitously.
U.S. Stock Market Index Volatility (USVIX)in 2011
Source: Trading Economics
In turn, we can expect that as the dispute drags on, while it may be hard to predict where asset prices will go, we can almost guarantee that without a swift resolution, it would not be unreasonable to experience further volatility, and potentially even worse than in 2011 if negotiations do end up more tense than twelve years ago. Rather than attempting to position a portfolio for a potential once in a lifetime default on U.S. debt, it may be advantageous for investors to make allocations to global macro hedge funds and multi-strategy funds, which have the institutional know-how and long-term track record navigating global economic crises, as well as the flexibility to quickly reposition themselves as conditions in Washington change.
- Reuters, Feb 2023, Factbox: The U.S. debt ceiling and markets: Gauging the fallout
- WSJ, Feb 2023, U.S. Could Default as Soon as July if Debt-Ceiling Standoff Isn’t Resolved
- Vox, Feb 2023, The lessons of the 2011 debt ceiling crisis, explained by the negotiators who were there
- CNBC, Feb 2023, U.S. will default this summer unless Congress raises debt limit, CBO warns
- FiveThirtyEight, Feb 2023, How This Debt Ceiling Debate Could End
- CNBC, Jan 2023, Yellen says Treasury is taking extraordinary measures to avoid default as U.S. hits debt limit
- Vox, Jan 2023, Our debt ceiling crisis could hit as early as June. Here’s how Biden can sidestep it.
- Brookings, Jan 2023, 7 things to know about the debt limit
- Reuters, Jan 2023, Explainer: A looming U.S. debt ceiling fight is starting to worry investors
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