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There has been a lot of news lately about the debt ceiling, but what exactly does that mean? According to Wikipedia, “In the United States, the debt ceiling or debt limit is a legislative limit on the amount of national debt that can be incurred by the United States Treasury, thus limiting how much money the federal government may pay on the debt they already borrowed.”
If Congress does not approve raising the current debt ceiling in the United States, our government might default on its debt obligations. If this happens, the economic fall-out could be catastrophic and send the financial markets into a tailspin. Unfortunately, the annual debt ceiling vote in the House of Representatives has become a political game of brinkmanship with nerve-wracking drama on both sides of the aisle. Here’s what you need to know.
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Timing
The last time the debt ceiling was raised was in December of 2021 to $31.381 trillion. This year, Congress needed to extend the debt ceiling again on January 23, 2023, also known as the “X” date. But that date came and went, and Congress did not approve a new debt ceiling. Secretary of the Treasury Janet Yellen had to use accounting tricks that she labeled as “extraordinary measures” for the U.S. government to keep paying the bills and avoid default on its debt obligations. These actions did buy some time, (most likely to early June), but if this deadline isn’t met, the rating agencies may be forced to downgrade the credit rating of the United States because of default.
The Problem
The national debt continues to rise year after year because of annual budget deficits. The first debt ceiling limit was set at $11.5 billion back in 1917, and the ceiling has been raised more than 100 times since then. Until we balance the annual budget, the debt ceiling limit must be increased every year. The last time we had a budget surplus was in 2001. Under President Clinton we had surpluses from 1998-2001. Since then, we haven’t had any. The Great Financial Crisis in 2008-2009 and the COVID-19 Pandemic in 2020 have only exacerbated these deficits with massive government spending.
The Issue
The Republican Party, led by Speaker of the House of Representatives, Kevin McCarthy, wants to use the debt ceiling issue to impose a spending cap in exchange for temporarily raising the debt ceiling. McCarthy wants Democrats to negotiate on federal government spending. President Biden has stated that he doesn’t want to be held hostage to any conditions.
The problem here is there aren’t any easy ways to reduce spending. The government can’t cut Social Security, Medicare, or fail to pay interest on the national debt. Defense spending might be an area where they could cut costs, but with the threat of China invading Taiwan and Putin’s invasion of Ukraine, that doesn’t seem likely or prudent.
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Déjà Vu
The last time the debt ceiling was so prevalent in the news was back in 2011, which ultimately led to the Standard & Poor’s rating agency downgrading the debt of the U.S. from AAA to AA+. Before this, the United States had the highest AAA rating since 1941.
This was a huge deal. A spokesman for the agency said, “the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenge.” Today, the political landscape is just as nasty as it was back then, and with rising interest rates causing an inverted yield curve, the U.S. could be headed for a recession in the next 12 months.
Ramifications
Once these extraordinary measures run out and the debt ceiling is reached in early June, the government will no longer be able to issue debt and will have no cash to pay its bills. Consequently, the federal government could no longer pay social security and salaries of government workers. Our government would effectively shut down. The Committee for a Responsible Federal Budget says “without enough money to pay its bills, any of the payments are at risk, including all government spending, mandatory payments, interest on our debt, and payments to U.S. bondholders. While a government shutdown would be disruptive, a government default could be disastrous.”
Market Reaction
The last time Congress and President Obama played a game of chicken with the debt ceiling and spending cuts, the stock market fell 16% in the five weeks between July and August of 2011. There is no reason to believe a severe and negative reaction wouldn’t be felt again. So far, neither the stock nor bond markets seem too concerned about the debt ceiling. Both have had a great start to 2023. Possibly by May, investors will start to pay attention to what Congress will do; until then, this issue doesn’t seem to be on the market’s radar yet.
Defaulting on our debt is financial Armageddon and not a viable option for Congress. Cooler heads must prevail as they did back in the summer of 2011. The fall-out for the stock, bond band U.S. dollar could be horrific for investors here and abroad. There is really no way to quantify the damage or years it would take to recover. This is one instance where the Federal Reserve likely can’t save the day. Powell doesn’t have the power to force members of Congress to pass any bills. Fortunately, over half the members of Congress are millionaires, so any financial damage from a default will be acutely felt by them as well.
Fred Taylor is a Partner, Managing Director at Beacon Pointe Advisors, LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed. Past performance is not a guarantee of future results.
Beacon Pointe has exercised all reasonable professional care in preparing this information. The information has been obtained from sources we believe to be reliable; however, Beacon Pointe has not independently verified or attested to the accuracy or authenticity of the information. The discussions, outlook, and viewpoints featured are not intended to be investment advice and do not consider specific investment objectives or risk tolerance you may have. All investments involve risks, including the loss of principal. Consult your financial professional for guidance specific to your circumstances.