Posted: May 14, 2023
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What is the Debt Ceiling?
Recently, the term “debt ceiling” has been constantly surfacing in the news. This article is an explainer of the “debt ceiling”, its importance, and why you should pay close attention to it in the weeks leading up to June 1st, 2023.
Firstly, what is the debt ceiling? As the name suggests, the debt ceiling is the maximum amount of federal debt that the U.S. Treasury can take on. In other words, the debt ceiling is a limit on the amount of money U.S. Treasury can borrow to finance existing government functions.
As of now, the total national debt and debt ceiling stands at US$31.4 trillion.
Why does the Debt Ceiling Exist?
Prior to 1917, the US Congress had to authorize the Treasury for every bond issuance.
At the start of World War I, the United States needed to borrow a lot of money via multiple bond issuances to fund the war. However, it was extremely inefficient for get congressional approval each time the Treasury wanted to borrow money. Furthermore, any delay in funding for its war efforts may well be the difference between life and death, victory and defeat.
As such, the Congress decided to put power in the hands of the Treasury by allowing bond issuances so long as the national debt stays within a predetermined limit for each type of bond. This marked the creation of the ‘debt ceiling’.
The debt ceiling gave the Treasury flexibility to borrow money to finance its war efforts in a timely manner. In 1939, a general debt ceiling was created. This prescribed a blanket limit covering on the issuances of most types of bonds.
The United States’ Colossal Debt – a Tale of Bad Spending Habits
Till date, the United States has amassed a colossal US$31.46 trillion debt, with debt held by the public accounting for 78.2% of the total national debt.
Total U.S. Federal Debt (US$ trillion, 1997 to 2023)
But, why does the world’s superpower even need to borrow money?
Well, whenever the government spends more than it earns from federal revenue, it needs to plug the gap by borrowing. The US Treasury borrows money by issuing securities, like U.S. government bonds, which promise full repayment with some interest (coupon) at a future date.
The government earns revenue from multiple sources including taxes, customs duties, leases of government-owned land and buildings, sale of natural resources, various usage and licensing fees, and payments to federal agencies.
Specifically, “Individual Income Taxes” and “Social Security and Medicare Taxes” form the two largest revenue stream for the federal government (see bubble chart below).
Revenue for the U.S. Federal Government by Sources, FYTD 2023
U.S. Government Spending by Category and Agency, FY2022 (%)
Since 2000, politicians from both parties (the Republicans and Democrats) have had a habit of borrowing to finance wars, tax cuts, bigger federal spending, care packages and other emergency measures. Spending programs have become politically popular today and retiring baby boomer are driving up the cost of Social Security and Medicare.
As a result, America has more than tripled its national debt in the past two decades, adding US$25 trillion in debt. According to the New York Times, this was caused by a political miscalculation at the end of the Cold War.
- In 1990s, America reduced spending on the military following the fall of the Soviet Union in December 25,1991. At the same time, a dot-com boom delivered the highest federal tax receipts in several decades
- At the turn of the century, America was flushed with tax revenue and light on military obligations. Many leaders thought this will extend into the future, but it didn’t last a year. The dot-com bubble burst, which reduced tax revenues. The September 11 attacks followed shortly, spurring the rearmament in Washington as President G.W.Bush engaged in the Iraq and Afghanistan wars
- To fund the wars, G.W.Bush did not raise taxes nor issue war bonds (which typically pay lower interest, and hence, adds less to the national debt). President Barack Obama, who inherited those conflicts, followed the same precedent set by his predecessor.
- As military spending surged, federal revenue also declined as a share of the economy as a result of tax cuts introduced by G.W.Bush. These tax cuts were meant to be temporary, but more than 4/5 of them were made permanent by Obama subsequently.
- In 2018, President Donald Trump signed in another round of Republican tax cuts, which were not offset by spending cuts.
- The biggest drivers of debt (often bipartisan / approved by both parties) have been the responses to the two recent sharp economic downturns – the 2008 financial crisis, and the 2020 COVID-19 pandemic. In 2009, Obama approved a US$800 billion package of tax cuts and stimulus spending. In 2020, Trump approved much larger aid packages amounting to more than US$3 trillion. In 2021, Joe Biden signed a US$1.9 trillion stimulus plan.
- These are irrefutably important spending and investments to help get the economy out of a deep recession, keep unemployment low and keep small businesses afloat. Yet, now we are faced with a whole new set of issue – the debt ceiling has been reached.
What Happens When the Debt Ceiling is Reached?
Upon hitting the debt ceiling, the Treasury can no longer issue securities to borrow money to plug the gap between the federal spending and its revenue.
In order to keep the “machine” going, the Treasury can take a few extraordinary measures to delay the need to raise the debt ceiling in order to meet its payment obligations.
They work by temporarily curbing certain government spendings so that the money can be used to pay the government’s obligations. Effectively, it is sort of a cookie jar movement – shifting money around the accounts to delay the need to pay for obligations.
Some examples of such “extraordinary measures” include the following:
- Scaling back of investments in a retirement plan for federal employees
- Temporarily moving money between government agencies and departments to make payments as they come due
- Suspending the daily reinvestment of securities held by the Treasury’s Exchange Stabilization Fund, a bucket of money that can buy and sell currencies and provide financing to foreign governments
Since the start of the year, the U.S. Treasury has been deploying such tactics to delay the need to raise the debt ceiling. But according to Treasury Secretary, Janet Yellen, these measures could be exhausted by June 1st, 2023.
What Happened in the Past when the U.S. was Approaching the Debt Ceiling?
This cataclysmic event is, in fact, nothing new to the markets / world. Since 1960, the U.S. debt ceiling has been raised 78 times under both Democrat and Republican presidents, most recently in 2021.
Source: Bloomberg Finance L.P., J.P.Morgan. Data as of April 20, 2023
According to the assistant Treasury Secretary, Joshua Frost, debt ceiling impasses have repeatedly disrupted the implementation of Treasury’s cash management policy – with knock-on effects for money markets. The Treasury Department usually has a daily cash balance of $600 billion to $700 billion, but during the 2021 debt limit standoff, there were days when it grew close to zero.
Case Study: 2011 Debt Ceiling Impasse
However, out of the 78 debt ceiling raises since 1960, the impasse in 2011 left the deepest mark.
The Congress reached a deal to raise the debt ceiling just 2 days before the X-Date. The date when the U.S. government could default on its debt if the debt ceiling is not raised is called the “X-Date”. Consequently, the Standard & Poor’s (S&P), a rating agency, downgraded the government’s credit rating from “AAA“ to “AA+”.
How did this affect asset prices?
Risk assets reacted strongly with the dollar and US equities selling off while credit spreads widened.
Treasuries, on the other hand, rallied as a result of money rushing into US treasuries because of other existing market fears like the European Sovereign Debt Crisis. Note that this is not related to the debt ceiling issue. It was the fear of the Eurozone debt crisis which drove investor money into the relative safety of US treasuries.
Gold hit its peak in August 2011 and started declining after.
How this could Play Out (3 Scenarios)
Scenario 1: The debt ceiling is increased ahead of the X-Date
- There has never been a default on treasuries in any of the past impasses that the U.S. had faced. Hence, raising the debt ceiling ahead of the X-Date is the most likely outcome.
- Investors are likely to avoid Treasury bills that mature at or around the X-date. This can be observed from the sharp spike in the yield on the 1-month treasury bill since late April 2023.
Scenario 2: Debt ceiling is not raised by the X-date, but the Treasury makes interest payments to avoid a technical default
- In such a case, the government will likely cut discretionary spending (and maybe mandatory spending too) to meet security payment obligations. This will come at the expense of economic activity and, undoubtedly, stir up the financial markets (given what we’ve seen in 2011)
- Another way to avoid default include calling upon the 14th Amendment, which states that “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned”. Effectively, lawmakers who crafted the amendment are strongly saying that once the US borrows money, it has to pay it back.
- However, Janet Yellen has downplayed the possibility of President Biden ignoring the debt ceiling by invoking the 14th Amendment, calling the idea “legally questionable”.
- Apart from raising the debt ceiling, Congress can also opt to suspend the debt ceiling, thereby allowing the Treasury to supersede the debt limit temporarily. This was rare before the global financial crisis of 2008/9, but the debt ceiling has been suspended 7 times since 2013.
Scenario 3: Debt ceiling is not raised by the X-date, and the Treasury delay payments (i.e., defaults)
- As mentioned earlier, this is the worst-case scenario. If this scenario plays out, there could be devastating repercussions for both the U.S. economy and the financial markets, which could further destabilize the U.S.’s authority as the world’s leading superpower
- As mentioned by Ray Dalio, the United States and China are on the brink of war with their constant engagement in brinksmanship. While they will not necessarily go to war, the two superpowers have been pushing each other’s red lines / boundaries.
- To make matters worse, many emerging nations are thinking about moving away from trading in the U.S. dollar. Commonly known as the “BRICS” (Brazil, Russia, India, China and South Africa), these nations represent more than 40% of the world’s population and almost a third of global economic output. The BRICS are in talks about establishing a common currency, a move which could dethrone the USD. That said, the establishment of a common central bank with common economic policies across these five geographically dispersed countries seem unlikely.
- Any default on U.S. treasuries would send a signal to the global economy that the U.S. economy is no longer as dominant as it once was; the dollar is no longer as stable as people thought, and; the U.S. treasuries are not the pristine collateral that they once were.
- Regardless, as with most things in the market, perception often matters more than reality. If people think that banks with a strong balance sheet will face a bank run, they will run and withdraw their money, thereby triggering an actual bank run. If the perceived credibility / creditworthiness of the US declines, it may trigger a sell-off in treasury and a shortage of “pristine collateral” in the global financial ecosystem. If the USD diminishes, it would undoubtedly have disastrous consequences for the U.S. in its bid to maintain as the leader in the current world order in the long term.
Why is there a Standoff if Things can get so Ugly?
Evidently, failing to raise the debt ceiling will prove detrimental to the U.S. economy and the wider financial ecosystem regardless of how things play out. However, it is noteworthy that such standoffs are not anything new. The decision to raise the debt ceiling is often highly political, with each party pushing to get its own agenda signed in.
Currently, the Republicans have proposed for the debt ceiling to be raised by US$1.5 trillion only if a US$4.8 trillion spending cut is implemented over the next decade.
On the other hand, the Democrats have refused to negotiate spending cuts over the negotiation of the debt ceiling issue – President Biden said he will only settle for an unconditional raise in the debt ceiling.
What is the Latest Status?
Over the past week, Joe Biden’s meeting with congressional leaders at the White House has not yielded any result and the two parties remain at an impasse. The leaders cancelled a planned meeting on Friday to let staff continue discussions.
In summary, it is very hard to imagine that the U.S. government will resort to a default before passing a bill to raise the debt ceiling. However, as we move closer to the X-date without a deal, we should expect some sell-off in the market. This could be a good time to scoop up some high-conviction equities.
Additionally, in-line with the golden rule of investing — diversification — it might not be a bad idea to pick up some gold (a safe-haven asset) in the short term to hedge against any likelihood of a default.
Be sure to keep your eyes peeled for any further updates on a potential debt ceiling impasse / default, and the next FOMC meeting in early-mid June.