Mind Your Head: Debt Ceiling Crisis Looms Again

We are now in the early stages of the perennial political melodrama over raising the debt ceiling. If this debate goes as usual, it should look like this: demands will give way to threats and lead to a fiscal cliff and government shutdown and the specter of default and global catastrophe before – whew! – an agreement is reached, and we await the next episode of the thrilling adventures of Congress and the White House. (Spoiler alert: This will be a repeat of the same old episode we’ve seen too many times before; the politicians and pundits have it on loop.)

What keeps us watching? The possibility that this time, maybe, the elected ones will decide to have a boffo finish and let the catastrophe happen, leaving us like Charlton Heston in the original Planet of the Apes: shaking our fists at the Capitol dome and screaming at the sky, “You finally really did it. You maniacs! You blew it up!” (Spoiler alert: Won’t happen. Probably. Maybe. We hope.)

What Is That Hanging Over Us?

The debt ceiling, or debt limit, is a curb imposed by Congress on the maximum amount of money that the federal government can borrow to meet its existing legal obligations. These obligations include Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments.

It’s important to note that raising the debt ceiling does not authorize new spending commitments. It simply allows the government to finance existing legal obligations that Congress and presidents of both parties have made in the past.

It’s also important to note that a stalemate over the debt ceiling is not the same as a government shutdown. A government shutdown occurs when a lapse in congressional appropriations causes federal programs considered “non-essential” to cease operations until new appropriations laws are passed.

Without such authorization, discretionary spending for non-essential government services—national parks, the Federal Trade Commission, passport services, food safety and environmental inspections—must stop. However, federal borrowing and spending considered essential—which includes interest payments on the national debt—can continue uninterrupted.

Today, the global market for U.S. debt is the biggest and most liquid debt market in the world precisely because the U.S. government pays what it owes.

By threatening to renege on payments already agreed to, in this case by refusing to give the White House the authority to pay the nation’s debts, the Republican majority in the House risks turning the United States into a deadbeat debtor. Uncertainty over the solvency of the U.S. increases the cost of borrowing in both the short and long term. And it is entirely possible that ratings agencies observing the dynamic will review the U.S. Treasury’s debt rating. A downgrade would further add to borrowing costs.

Except for about a year during 1835–36, the United States has continuously had a fluctuating public debt since the U.S. Constitution legally went into effect on March 4, 1789. Debts incurred during the American Revolution and under the Articles of Confederation led to the first yearly report on the amount of the debt.

According to the U.S Treasury, since 1960 Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit—49 times under Republican presidents and 29 times under Democratic presidents. It has never been reduced.

The United States is essentially the only country that requires a separate vote on the debt ceiling. Denmark is the only other nation with a formal debt ceiling, but the Danes’ limit is so high that they don’t come close to breaching it. When Denmark once got somewhat close to its debt ceiling in 2010, leaders simply doubled it.

A Short History of the Debt Ceiling

The debt ceiling was created by Congress in 1917 via the Second Liberty Bond Act. Prior to that, the United States did not have a debt ceiling. Instead, Congress either authorized specific loans or allowed the U.S. Treasury to issue certain debt instruments and individual debt issues for specific purposes. Sometimes Congress gave the Treasury discretion over what type of debt instrument would be issued.

Between 1788 and 1917, Congress authorized each bond issue by the U.S. Treasury by passing a legislative act that approved the issue and the amount. The legislators did not focus on the cumulative amount.

The Second Liberty Bond Act of 1917 allowed the U.S. Treasury to issue bonds and take on other debt without specific Congressional approval, as long as the total debt fell under the statutory debt ceiling. The 1917 legislation set limits on the aggregate amount of debt that could be accumulated through individual categories of debt (such as bonds and bills).

In 1939, Congress instituted the first limit on total accumulated debt over all kinds of instruments. The debt ceiling, in which an aggregate limit is applied to nearly all federal debt, was substantially established by Public Debt Acts passed in 1939 and 1941, and this legislation subsequently amended. This measure gave the Treasury freer rein to manage the federal debt as it saw fit. Thus, the Treasury could issue debt instruments with maturities that would reduce interest costs and minimize financial risks stemming from future interest rate changes.

The debt ceiling was raised to accommodate the raising costs of World War II in each year from 1941 through 1945 when it was fixed at $300 billion. After the war, the debt limit was reduced to $275 billion. Because the Korean War was financed by taxes, the debt ceiling remained at $275 billion until 1954.

Hitting the Ceiling

The national debt is the total amount of outstanding borrowings by the U.S. Federal government, accumulated over our history. The Federal government needs to borrow money to pay its bills when its ongoing operations cannot be funded by Federal revenues alone. When this happens, the U.S. Treasury creates and sells securities, and these securities are the debt owed by the Federal government.

There are many different types of Treasury debt; bills, notes, and bonds are the most common ones. The various types of debt differ primarily in when they mature—ranging from a few days to 30 years—and in how much interest they pay.

If the government hits the debt ceiling and exhausts all other options, it can no longer borrow. Since the government runs an annual deficit, it will run out of money soon after it hits the limit and temporarily default on obligations.

If the Treasury can no longer borrow and exhausts other available methods to make payments, the federal government would eventually be forced to miss, delay, or reduce payments that it is obligated to make. This would call into question the full faith and credit of the United States as an entity. If the Treasury is not able to borrow additional money, the U.S. could default on outstanding loans, and its credit rating may be downgraded by credit rating groups. A default would negatively impact the global economy and international financial markets as well.

Extraordinary Measures

Once the debt limit kicks in, the Treasury cannot issue any more debt—but it still must keep paying the bills; therefore, it can only draw from any cash on hand and spend its incoming revenues.

The U.S. Treasury can also take certain extraordinary measures to extend how long it can continue to pay all the government’s obligations while staying below the limit. The idea is that this will buy time for Congress to authorize more borrowing, at which time everything will be trued up again. This period of extraordinary measures is where we are now and where we will be for the next couple of months. The reservoir of extraordinary measures is estimated to be about $400 billion.

These measures include accounting techniques within several government accounts that temporarily reduce the amount of U.S. Treasury securities issued to those accounts, including suspending new investments and redeeming existing investments early. By reducing the amount of outstanding Treasury securities, the level of outstanding debt temporarily falls, slightly extending the amount of time that the government can continue to satisfy its obligations. Based on projections of federal cash flows, this should tide the Treasury through to the middle of the summer 2023.

These measures also include shifting money around different government accounts to fill the gap until more borrowing is allowed to catch up. Examples include suspending retirement contributions for government workers and repurposing other accounts normally used for things like stabilizing the currency.

About Those Incoming Revenues …

If the Treasury Department uses all its extraordinary measures and cash, the government would have to pay all its obligations using only its incoming revenues. If these revenues happened to cover the promised payments, then the government would be able to meet its obligations.

However, there are some issues that complicate this approach.

First, the spending and revenue decisions were made in previous legislation enacted by Congress and presidents from both parties. That previous legislation determines the relative sizes of revenues and spending today. For example, if the federal government has agreed to pay $10, but it only has $6 of revenue coming in, $4 of promised payments cannot be made unless additional debt can be issued to pay for it. Those promised payments could include programs such as Social Security, Medicare, and national defense spending.

Second, timing mismatches between spending and revenues mean that, more generally, the revenues would not cover the spending obligations. In certain weeks and months, it would be harder for the Federal government to meet its obligations than in others.

Federal spending and revenues are both highly seasonal, meaning that they vary widely depending on the time of year, and they are often not aligned. Fortunately for the Treasury, we are also heading into the interval where monthly tax receipts exceed expenditures, which reduces the need to borrow.

Conclusion: After the Show, the Bills Will Be Paid

Setting aside politics, we as investors care about the debt ceiling for several reasons. First, cutting off government payments will hurt economic growth. Limits on, for example, Social Security payments would severely hurt both economic demand and confidence. While Social Security would likely be the last thing cut, if possible, other cuts would also hurt growth and confidence. We saw exactly this in prior similar situations, and the damage was real.

The bigger problem, however, is that the Treasury market could go into default if payments to holders of U.S. debt are not made. U.S. government debt has always been the ultimate low-risk asset, where default was assumed to be impossible. So, adding a default risk would raise interest rates, potentially costing the country billions over time. The economic risk, both immediate and long-term, is very high.

Still, it’s not the end of the world. Any default this time around would be political, not economic. When countries default because they can’t pay, that is a systemic problem; the lenders won’t be getting their money. In this case, though, we can pay and will, eventually. It will just take some time to get through the political process.

Don’t panic. This has happened before and will no doubt happen again. The pundits and politicians are making the most of what might happen—and the worst case would indeed be bad. But the markets appear to expect the same old ending again, with the debt ceiling raised after the maximum TV ratings and political leverage have been wrung from the situation. No one is seriously talking about repudiating or truly defaulting on U.S. debt, and the markets are reflecting that.

We have months to go from here to there, during which there are enormous incentives to come to an agreement. And even if an agreement is not reached, there are other, non-default options to deal with a debt ceiling crisis. If we do default, the resulting market volatility will likely force the politicians to come to an agreement.

There are many ways to solve this problem, and only one way to fail.

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