The Debt Ceiling Showdown

By Steve Gelber on May 26, 2023

As the unofficial start of summer quickly approaches, investors may be thinking less about barbecues and be instead focused on the looming debt ceiling debate that is in crunch time on Capitol Hill.  The United States is drawing closer to what Treasury Secretary Janet Yellen has estimated is a June 1^st deadline that, without action by Congress to raise the debt limit, the government would face an “imminent threat” of default on its debt obligations.

What is the debt ceiling?

The debt ceiling refers to a statutory limit on the amount of money that the U.S. government can borrow to meet its financial obligations. The U.S. Constitution, ratified in 1788, granted the federal government the power to borrow money.  However, the framers of the Constitution recognized the potential dangers of excessive debt and included provisions to ensure fiscal responsibility.

Over time, the debt ceiling evolved into what we now know today. The Second Liberty Bond Act of 1917 allowed the U.S. Treasury to issue bonds to finance the war effort during World War I, but to exert some control over the nation’s escalating debt, Congress imposed a statutory limit on the amount of bonds that could be issued. In the following years, the debt ceiling underwent several modifications and amendments, and its level was adjusted periodically to accommodate the country’s changing economic needs. The most notable being in 1939 when Congress enacted the Public Debts Act which removed the distinction on different types of debt issued by the government and housed all types of debt obligations under one limit.  Under a revision in 1941 all that debt was consolidated under the U.S. Treasury and the tax-exemption for interests and profits on government debt was eliminated.

The debt ceiling served as a useful tool to ensure responsible borrowing until the latter half of the 20th century. As the increased complexity of the U.S. economy, rising federal spending, the expansion of government programs, and economic crises, led to a series of confrontations between Congress and The White House regarding the debt ceiling a rising limit became a more frequent occurrence. In fact, over the last 82 years of the modern debt ceiling—the limit has been raised over 100 times.

We’ve been here before….

Raising the debt ceiling, a once routine Congressional act, to allow the Treasury to continue borrowing to meet already incurred bills, has evolved into a political leveraging tool.  The limit has been raised more than 100 times in modern times to keep the government running, but by turning the debt ceiling into a last minute “must pass bill,” both sides can attempt to load that bill up with other priorities.

In this Congress, Biden and the Democrats have insisted on a “no strings attached” raise to the debt ceiling while House Republicans have refused to raise the limit without Federal spending cuts and restrictions on future spending. In furtherance of the Democrats’ position, they have indicated that they would attempt to invoke an unprecedented use of language in the 14^th Amendment that “The validity of the public debt….shall not be questioned” as authority to bypass the debt ceiling and allow the Treasury to issue new debt since allowing a default would be, in their interpretation, unconstitutional.  We don’t see this as a likely option as any such action would be unprecedented, face immediate legal challenges, and further complicate an already complex situation.

The debt limit has been looming for months, yet both sides have been posturing and not seriously coming to the table for discussions until just this month.  Just this week, both sides have finally made positive remarks that they are drawing closer to a “bipartisan deal.”

In the past, there have been instances of last-minute agreements and temporary suspensions to avert a default. However, the debt ceiling debate has often been marked by political gridlock and contentious negotiations, leading to uncertainty and potential market disruptions.  Most notably, in 2011 Standard and Poor’s downgraded the United States’ debt due to protracted debt ceiling negotiations which was an unprecedented event that had wide market implications.  The U.S. debt downgrade served as a wake-up call for policymakers, highlighting the urgent need to address long-term fiscal sustainability and reduce the budget deficit. It sparked debates about the country’s fiscal trajectory and the potential consequences of political inaction.  As America gets older, our memories get shorter, however, as on May 25, 2023, Fitch (another rating agency) warned of a “negative outlook” on U.S. debt considering the current debt ceiling negotiations, which puts the government on notice of the risks of another potential downgrade.

What if Congress doesn’t make a deal?

Twice in the past decade, politicians have failed to come to an agreement before the “X-date” given to them by their Treasury Secretary–and it is possible that may happen a third time.

In this political game of chicken, there is a real possibility that each side believes that growing political pressure, market volatility, and economic uncertainties, will force the other side to cave. In addition, with two prior negotiations extending past the “X-date,” some politicians may feel they can disregard warnings.

While we would hope this is not the case–the government does have tools at its disposal to push off a default, albeit for a period of time. Every year, the U.S. government spends far more than it takes in and must increase its outstanding debt to do so. While the government can control the timing of its spending, budget officials can only guess as to the timing of tax receipts. Thus, they can provide only imprecise estimates as to when the government may “run out of money.” Moreover, running into the debt ceiling does not mean that all government functions will come to a halt. It simply means that Washington can no longer spend more than it takes in. At that point, the government will prioritize spending on items deemed essential and may cut lower-priority outlays. The Congressional Budget Office has a considerable amount of useful and publicly available information, including a decomposition of spending into “essential and nonessential” expenditures. 

So what does it mean for investors?

The consequences of a failure to raise the debt limit would have far-reaching impacts on individuals, businesses, and the overall economy. The risks and repercussions of such an unprecedented event emphasize the urgency and importance of reaching a resolution to ensure the continued functioning and stability of the U.S. financial system.  As such, we do have faith that Congress will come to agreement and pass a bill to raise, or suspend, the limit. Though, investors should be ready for the potential for increased volatility in equity, and potentially in fixed income markets, in the short term. For long term investors, we see volatility as potential buying opportunities, while for our retirees we have already accounted for short-term cash flow needs as part of their overall financial plans.

As always, we stress remembering that volatility is short-lived, stick to your financial plans, and should you have any questions, please do not hesitate to contact our office.