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U.S. debt has grown faster than national income for more than fifty years, and according to
the US Constitution, Congress has to authorize all borrowing.
A debt limit was put in place in the early 20th century (as part of the Second Liberty
Bond Act of 1917) so that the Treasury wouldn’t need to ask for permission each time it had
to issue debt.
A general limit on the federal debt was then imposed in 1939.
The US government hit its borrowing limit yesterday and The US Treasury is now taking
“extraordinary measures” to meet its debt obligations.
Let’s talk about why people are a bit more concerned about the debt limit today than
they have been in the past and what happens if congress doesn’t agree to lift the debt
ceiling.
So, the US Department of the Treasury pays the US government’s bills, and to do this,
they issue debt.
Whenever the debt ceiling is reached, it can be raised by a simple majority vote in both
houses of Congress.
If Congress refuses to raise the debt limit, the Treasury then finds itself unable to pay
the government’s bills once its bank account at the Fed runs out.
Janet Yellen, The U.S. Treasury Secretary wrote a letter to Congress last week warning
that the debt ceiling would be hit this week, and that the Treasury would have to take “extraordinary
measures” to prevent the U.S. from defaulting on its obligations.
Yesterday that debt ceiling was hit, and the US Treasury is now taking those “extraordinary
measures” so that it can meet its debt obligations.
The extraordinary measures can only be expected to buy a few months of time, meaning that
we can expect a showdown between the Biden administration and lawmakers on Capitol Hill
in the next few months.
Now, to be clear, the debt limit does not authorize new government spending.
It simply allows the government to finance legal obligations that they have already committed
to.
Spending that Congresses and presidents of both parties have made in the past.
The spending being discussed has already happened, it’s simply paying for that spending that
is being discussed.
Of course the Republicans in opposition who are opposed to high government spending are
aware of this, but they can use the debt ceiling approval process to extract promises to reduce
future spending and borrowing.
They might use this leverage to try to roll back some of the spending involved in the
recent Inflation Reduction Act for example.
In her letter Janet Yellen wrote that “Failure to meet the government’s obligations would
cause irreparable harm to the US economy, the livelihoods of all Americans, and global
financial stability,” and that is true.
Now this debt ceiling debate has of course happened quite a few times already, and investors
have gotten used to the drama.
Legislators negotiate, make threats and then at the last minute get their act together
and agree.
The debt ceiling was increased 90 times in the 20th century.
It was raised eighteen times under Ronald Reagan, eight times under Bill Clinton, seven
times under George W. Bush, and five times under Barack Obama.
There is nothing new about this.
Now, whenever it looks like an agreement on the debt ceiling won’t be reached, the same
solutions are put forth as a means to allow the government to avoid default.
One is the president invoking his 14th Amendment authority to pay the government’s bills;
the other is the minting of a trillion-dollar coin to refill the government general account.
Matt Yglesias, a well-known blogger and journalist has recently argued that the government could
solve this problem by issuing premium bonds.
The problem with each of these solutions is that they are legally questionable and reek
of desperation.
They are not the best solutions to the problem.
So, is this debate just another storm in a teapot where we will have to see #just mint
the coin trend on social media for a few months before congress ups the debt ceiling, or might
it be different this time?
If it is different this time, how might markets be impacted?
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The reason that investors fear that the debt ceiling debate might be more dramatic this
time around is quite simply that congress appears to be more chaotic this time, than
at any point in recent history.
Kevin McCarthy, the Republican House majority leader became the first party leader in a
century to fail to be elected Speaker in the initial round of voting.
He was finally elected after three days - on the 15th round of voting.
This number of votes was last surpassed in the run-up to the American Civil War.
The reason that this might be a problem for markets is that any time there is a difficult
or controversial question that needs to be settled by the House, we could see a replay
of this drama.
This time the worry isn’t about a division between Republicans and Democrats, it’s
that small group of rebels within the Republican Party could obstruct the goals of mainstream
Republicans.
The worry is that the US might have a congress that are unable to agree on anything.
There is of course a range of possible outcomes.
The least worrying outcome is that there is some chaos and drama around the debt ceiling
which causes volatility in the stock and bond markets, but eventually some compromises are
made, and a deal is reached.
The last few times we have seen this sort of drama (2013, 2018 and 2021) things mostly
worked out (unlike in 2011, when the squabbling caused US debt to be downgraded by ratings
agencies).
The credit downgrade in 2011 contributed to the Stock market falling 11 percent over a
two-week period.
The day the credit downgrade was announced on the 8th of August, the S&P500 had one of
its worst one-day declines in market history.
It fell 6.7% that day with all 500 stocks and all ten industry groups declining.
It wasn’t just market volatility either, there was a real cost.
The US Government Accountability Office estimated that the fight over raising the debt ceiling
in 2011 raised borrowing costs for the government by $1.3 billion that year.
The Bipartisan Policy Center extended the GAO’s analysis and found that the scuffle
ended up raising borrowing costs for the country by $18.9 billion over ten years.
A more worrying outcome for investors is that congress could use the debt ceiling as leverage
to force though temporary or permanent government spending cuts.
Companies whose revenues come largely from the federal government could come under pressure
under those circumstances.
Defense stocks that have done quite well over the last year could come under pressure if
government spending was cut as could infrastructure companies.
Companies who benefit from Bidens Inflation Reduction Act could see reduced earnings expectations
if government spending is reduced.
This is not guaranteed though.
It is worth noting, that a lot of the budget-cutting measures that were enacted to get the debt
ceiling raised in 2011 (the Budget Control Act) were mostly reversed, with both Republicans
and Democrats blaming each other for any problems that were caused.
Republicans quickly began arguing that the budget cap should be lifted for defense spending
for example.
The most worrying outcome, which I should be clear is quite unlikely is that congress
squabble enough, that the US actually misses an interest payment and falls into default.
There are some political analysts saying that this is a reasonable possibility.
Mark Zandi, the chief economist at Moody’s says that there are senators and congresspeople
openly contemplating a breach [of the debt ceiling].
Should a default occur, it could be very costly for the United States.
In 1979, while Congress did manage to raise the debt ceiling right before a default would
have been unavoidable, the failure of some 1970’s era word processing equipment used
to print checks meant that the Treasury couldn't get the checks printed on time.
Even though investors received their payments with only a small delay, T-bill yields jumped
by 60 basis points that day and remained elevated for several months thereafter.
The cost to taxpayers was in the tens of billions of dollars.
This 1979 default was, of course, temporary, and driven by a technological problem, not
an unwillingness to pay.
The Treasury did pay the $120 million dollar shortfall after a short delay but balked at
paying additional interest to cover the period of delay.
After some legal arm twisting and new legislation, the Treasury made all investors whole for
that additional interest.
You might say that this event in 1979 wasn’t a real default, it was just a back office
mix-up and the disruption applied to only a tiny amount of the nation’s debt – mostly
T-bills owned by individual investors.
But a debt default occurs anytime a creditor fails to make a payment on time and by that
standard, the United States did default that year.
It was small.
It was unintentional.
But it was a default, and it was an expensive mistake for the country.
This doesn’t need to be deliberately repeated on a larger scale.
So, what are the ‘extraordinary measures’ the Treasury is taking so that it can keep
meeting its obligations?
Well, in order to generate additional borrowing capacity and stretch out the remaining cash
on hand, Janet Yellen has said that the Treasury would first suspend new investments in various
government accounts and make amendments to the Thrift Savings Plan for federal employees,
which invests in non-marketable securities that mature every day.
Under statutes designated by Congress, the Treasury can pause reinvestments for now and
these funds would be made whole after the debt ceiling situation is resolved.
Once those measures run out, the Treasury would then likely begin prioritizing certain
payments over others so that they can continue making interest and principal payments on
the government’s debt and avoid default.
Programs at risk could include things like federal salaries, social security, military
healthcare coverage, things like that.
In the past we have seen situations where certain government employees are asked to
continue going to work without paychecks and others are sent home without pay.
In the past we have seen things like National Park services being shut down due to partial
government shutdowns.
A process where the Treasury starts choosing who to pay and when to pay them would be both
expensive and stretch the limits of the Treasury Department’s financial technology systems.
They are not set up for this.
So, what does the political situation look like?
Well, Kevin McCarthy, the new Republican House speaker, said that he had “a very good conversation”
with Joe Biden last weekend and said that he told the president he wanted to “sit
down with him early and work through these challenges” which could be positive.
McCarthy is however in a very weak position within his own party to push any compromise
on rebellious party members, after agreeing last week to a rule that would allow any single
lawmaker to motion to remove him from his post.
So, what about the various solutions that people are proposing like minting a trillion-dollar
platinum coin?
OK, so the coin argument has been around since the Obama administration’s debt ceiling
fights.
The argument is that in 1996 a modification of the coinage act passed Congress that gave
the US Treasury the authority to mint platinum coins of any denomination.
The law was intended to allow the Mint to make money from coin collectors and it gave
the Treasury secretary the power to mint platinum coins of any denomination.
So a platinum coin wouldn’t need to have a trillion dollars’ worth of platinum in
it, it could just be given that face value.
People argue that the treasury could mint a trillion-dollar coin, deposit it at the
federal reserve thus providing a means for the Treasury to fill up its bank account and
continue to make payments without violating any statute or provision of the constitution.
Another argument is that the president could simply invoke the 14th Amendment to pay the
government’s bills.
Bill Clinton said back in 2011, that during his budget standoff with Republicans, his
staff researched the constitutional implications and that he would have used the 14th Amendment
“without hesitation and force the courts to stop him”.
In 2011 Barack Obama said he had talked with his lawyers, and they were “not persuaded
that that’s a winning argument.”
Finally, the premium bond argument is that the treasury could issue bonds with really
high interest rates to replace existing bonds as they expire.
Investors would pay more for these bonds than their face value, but the national debt would
just go up by the face value of these bonds.
The debt limit statute applies to “the face amount of obligations” issued by the government,
not their actual value.
To start with, the Biden administration has already said that they don’t intend to take
executive action to avoid a default without congressional intervention.
The problem with all of these solutions is that they are gimmicks, they are legally questionable
and the desperation of using these gimmicks could scare markets almost as much as a default
would.
I’m not sure that they would be as bad as a default, but they would highlight real disfunction
in the US government.
Yesterday, Janet Yellen sent the letter confirming the breech of the debt ceiling.
She cautioned that there is “considerable uncertainty” surrounding how long the “extraordinary
measures” that are now being taken could continue before the US government defaults.
She urged lawmakers to move quickly.
Yellen has previously said that it is “unlikely” that the government would run out of cash
before “early June”, but there are a range of estimates as to when the US would run up
against the possibility of default.
The timing of the cliff-edge depends on a list of factors, including things like incoming
tax receipts.
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