Feb 17, 2023
Debt ceiling drama
It’s a new year, and Washington is again engaging in its favorite game of “Do we raise the debt ceiling?” Once a routine non-event, raising the debt ceiling has now become a veritable political hot potato. On January 19, 2023, the U.S. government reached its $31.4 trillion borrowing limit.1 And while Treasury Secretary Janet Yellen enacted extraordinary measures to allow the federal government to continue to pay its obligations on time and in full until June, at some point (soon), Congress will need to raise the debt ceiling or risk causing the U.S. to default on its debt, which would likely result in serious negative economic implications around the globe.2
If you feel like we’ve been here before, it’s because we have. As the late, great Yogi Berra famously said, “It’s déjà vu all over again.” So, with the debt ceiling debate likely to dominate headlines in the weeks and months to come, it might be helpful to put this whole manufactured crisis into context.
What is the debt ceiling?
When the U.S. government runs a deficit, it must borrow to fund the shortfall. The debt ceiling is the legal limit on the total amount of debt the U.S. government can accrue. To exceed that limit, the debt ceiling must be raised by Congress. Otherwise, the Treasury will run short of money to pay federal employees’ salaries, make Social Security payments and provide veterans’ benefits, among other things.3
Why does the debt ceiling exist?
The debt ceiling was first implemented in 1917 when the U.S. entered World War I. Before then, Congress had to authorize each loan, which was a slow and cumbersome process. By putting in place a debt ceiling, it was easier for the U.S. government to issue bonds to fund the war effort. At first, there were multiple debt ceilings, which were eventually combined in 1939 into the single debt ceiling we know today.4
Does raising the debt ceiling give the government license to spend more money?
This very question cuts to the heart of the current debate in Congress. The short answer is no. The debt ceiling represents money already spent, not future spending. Not raising the debt ceiling is akin to not paying one’s credit card bill. Deficits and debt are terms often used interchangeably, which is incorrect. Deficits represent new shortfalls the government must borrow to cover, while debt represents money borrowed in the past.5
What if Congress fails to raise the debt ceiling?
In short, the government would no longer be allowed to issue new debt and soon run out of cash on hand. If tax receipts are insufficient to pay obligations as they come due, the U.S. would be forced to default on many of those obligations. That could roil global financial markets that depend on the economic stability and creditworthiness of the U.S. Interest rates for Treasuries would increase, affecting rates on car loans, mortgages, credit cards, etc.6
But this time, it’s different, right?
The circumstances and dynamics are always different.
What does this mean for my portfolio?
We believe the likelihood of the debt ceiling not being raised and the U.S. defaulting on its debt is a high-risk, low-probability event. Those types of events are extremely difficult to protect against because they require taking a highly defensive position similar to buying portfolio insurance. If one guesses wrong, the opportunity cost is high (i.e., considerable return left on the table). And even if one guesses right, the cost of maintaining that defensive position in the midst of a market calamity could be sizable.
What do the markets think about the debt ceiling debate?
In August 2011, the U.S. credit rating was downgraded when debt ceiling negotiations stalled. Stocks sold off—temporarily. And bonds? They actually rallied as investors piled into the safe haven of Treasuries.7 If investors believed the U.S. was headed for a similar outcome this time, one might expect stock prices to reflect that. However, it’s been the opposite, as stocks had an excellent January following a nicely positive fourth quarter of 2022.8 As for bonds, if the U.S. were at risk of a downgrade or default, bond yields would likely rise. However, it’s been the opposite, as yields have fallen across the board to start the year, causing bonds to rally.9
Why is this even up for debate?
Now you’re asking me to get inside the heads of politicians—a scary thing indeed! This is not the first time the debt ceiling has been used to pursue deficit reduction. However, in the past, major deficit reduction agreements were usually accompanied by a debt ceiling increase rather than making one contingent on the other.
Given the political polarization in Washington, it’s easy to imagine a political standoff worse than that of 2011, when the U.S. was pushed to the brink of default, triggering a credit rating downgrade. However, there is a key difference between 2023 and 2011. In 2011, the Republicans held a 24-seat majority in the House versus a 4-seat majority now. We believe the smaller majority gives Republicans a lot less leverage to demand concessions from the Democrats and President Biden, who, unlike President Obama in 2011, has indicated an unwillingness to negotiate.
Besides, holding the economy and markets hostage to a political negotiation is an extremely risky game to play and one in which there are no winners. In the end, the hope is that cooler heads prevail and the debt ceiling is raised by the deadline.
ABOUT THE AUTHOR
Matt Reznik, CPA, MBA, CFP, CFA
As a member of the Investment Committee, Matt is instrumental in developing BDF’s overall investment strategy. Matt received his Bachelor of Science in Economics with concentrations in accounting and finance from the Wharton School of the University of Pennsylvania and his MBA in finance and strategic management from the University of Chicago Booth School of Business. He's been with BDF since 2001.
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