What is the debt ceiling?
The US debt ceiling is a limit on the total amount of outstanding securities that the US government is legally allowed to have issued to finance its budget deficits and thus meet its obligations, such as interest on existing national debt, social security payments, tax refunds and other payments. It was first created by Congress in 1917 in response to the massive expenditure outflows associated with World War I with the aim of increasing flexibility whilst ensuring fiscal responsibility. Since then, the limit has been raised over 100 times, with the cap currently set at $31.4trn.
Why is the debt ceiling hitting the headlines now?
The Treasury reached the $31.4trn statutory borrowing cap at the start of the year and since then has relied on so called 'extraordinary measures' to fund government operations whilst Congress acts to raise or suspend the debt ceiling. These extraordinary measures are simply fiscal accounting tools utilised to meet obligations, such as suspending investments in savings plans for federal employees. The idea is that once the cap is lifted or suspended the Treasury will backfill the missing payments.
The issue is that these extraordinary measures cannot be used indefinitely and will soon be exhausted, possibly as soon as 1 June depending on net budgetary flows, at which point the debt ceiling will be binding - this is commonly termed the ‘X-date’. Before that happens, there is also an immediate concern that the Treasury’s room to respond quickly to an economic shock – such as a banking crisis – might be constrained by the debt limit. Helpfully though, in response to the recent banking turmoil, it was the Fed (rather than the Treasury) that stepped in with an emergency loan programme to the banks, which stabilised the situation without further reducing the Treasury’s cash balances.
What is Congress doing to avert a debt crisis?
In an attempt to avoid the catastrophic outcomes of a US debt default, Congress has been working on a bipartisan agreement to try and lift the debt ceiling. However, negotiations appear to be at a stalemate with neither the Republicans nor the Democrats seemingly willing to compromise. The Democrats are campaigning for a clean debt ceiling increase, separate from any other bills, in contrast to the Republicans who are demanding that it be paired with substantial spending cuts and reversals to key elements of the White House agenda. Although President Biden is reportedly prepared to visit spending cuts once the debt ceiling has been raised or suspended, as it stands he appears unwilling to entertain the idea of linking the two bills, arguing that the Republicans are 'holding the economy hostage' with their spending cut demands. The debate is complicated further by Republican McCarthy's tentative position as House Speaker, with the concessions agreed to get him the votes needed to be secured as House Speaker leaving him vulnerable. The most significant was the agreement that any single member can call a vote of no confidence to oust him from office. As such McCarthy only has a limited power of persuasion and room to manoeuvre against a caucus of Republican Congressmen that are challenging him not to be the first to blink in regard to spending cuts.
Has the US come close to default before?
There is a precedent of such a situation where negotiations took place right up to the deadline driving substantial market volatility. The debt ceiling crisis of 2011 is the prime example, where a resolution was agreed only two days before the X-date. The situation has many parallels with today. Back in the summer of 2011 the GOP was also demanding significant spending cuts as the price for a debt ceiling increase, the scale of which the Democrats were unwilling to agree to. In the end a compromise was reached and the Budget Control Act of 2011 was passed, initially increasing the debt ceiling by $900bn whilst also setting out expenditure reductions. But the events that unfolded over the days preceding the deal did not come without its consequences, notably the credit rating downgrade of US government debt by S&P (to AA+) for the first time in history.
Although the 2011 saga was the closest the US economy has been to a default, there have been other occasions in US history where debt ceiling negotiations have reached a stalemate causing vast uncertainty.
Past episodes of debt ceiling uncertainty
|Control of the Senate / House?
|1995 - 1996
|Bill Clinton (D)
|Republican Senate and House
|House Republicans demanded tax cuts and a balanced budget within seven years in exchange for debt ceiling support. Moody's considered downgrading the US credit rating, a threat which eventually resulted in the Republicans passing the debt ceiling increase with more modest concessions.
|Barack Obama (D)
|Democratic Senate and Republican House
|The debt ceiling was increased only two days before the US Treasury was set to run out of funds to meet its obligations after infighting between the Republicans and the Democrats over spending cuts. S&P downgraded the US to AA+.
|Barack Obama (D)
|Democratic Senate and Republican House
|Congress failed to reach an agreement on the debt ceiling resulting in a 16-day partial government shutdown. This ended once Obama signed a bill which suspended the debt limit, just weeks away for the 'X-date'.
What are the chances of a lack of resolution? Are there other options?
History points to the various sides in the US always having managed to come to an agreement, albeit as in 2011, close to the wire. Arguably though this time the two sides are further away than ever. This at least partly reflects the internal politics of the Republican party. Speaker of the House Kevin McCarthy was only elected to his position after a near unprecedented 15 rounds of voting. As a compromise to the right wing of his party it was agreed that McCarthy would be subject to a vote of censure if just one House member calls for it, putting pressure on him to hold out against conciliation with Democrats until late in the day.
By contrast President Biden is said to have other routes forward to bypass the need for an agreement. Specifically, the two options are:
- Invoking the 14th amendment to the constitution which reads: 'The validity of the public debt of the United States, authorized by law… shall not be questioned'. This would argue that, in legal terms, the constitution supersedes the debt ceiling and that the US Treasury is entitled to issue debt beyond the $31.4trn limit. This is a risky course of action as it would be likely to usher in a legal challenge from the Republicans with a risk that the Supreme Court rules against the administration.
- It has also been suggested that the Treasury could instruct the US Mint to create a $1trn platinum coin, pass it over to the Fed and continue to settle obligations. This is technically feasible given a 1997 law which enables the Treasury to create large value coins to profit from bullion. Treasury Secretary Yellen however recently disagreed about the viability of such a scheme, dismissing it as a gimmick.
Our sense is that an agreement will probably be reached by the X-date, with the Democrats perhaps agreeing to modest spending cuts. However, it is impossible to be confident about this - there is a material risk that neither side blinks and the debt ceiling becomes binding.
Will the US default if the sides reach the X-date without an agreement?
In our view probably not, at least for a while. The common view is that the US would default due to an inability to refinance expiring debt or to make coupon payments. However, to avoid a default the Treasury could choose instead to try to prioritise specific expenses, for example, delaying payments to agencies and suppliers (and perhaps even workers) and still meet its debt obligations. Remember of course that simply rolling debt over would not increase the amount of gross debt, so that if expenditure were kept firmly in check, the Treasury could meet redemptions by issuing new securities and pay coupons to investors, thereby avoiding a default.
The scale of the necessary expenditure savings though would be huge. Indeed the Brookings Institute has estimated that the government would need to cut (non-interest) spending by up to 35% to enable it to meet its debt related obligations. Given the chaotic repercussions that would ensue from large groups in the economy not being paid, this would be highly undesirable and in all likelihood would have a very short shelf life. But the administration might prefer this option to a default for a short space of time following the X-date. We would also note that the Federal government had a contingency plan more or less to this effect during the 2011 debacle.
What do markets think?
Markets have lately become more concerned about the risks of a default. However, while the US dollar is generally weaker since the end of April it is of course not possible to disentangle the effects of these fears from other factors which might depress the greenback, such as the recent banking issues and the broader macroeconomic outlook.
But where the pointers are much clearer is in the short-term US debt markets, particularly those securities that are set to mature soon after the X-date. One month Treasury bill yields, for example, have risen sharply over the past month and by more than the equivalent interbank (OIS) rate. In fact, over the past couple of weeks, 1-1½ month T bill yields have been frequently above the equivalent OIS swap rates. For comparative purposes, this compares with a typical spread of some 40bps in favour of OIS. In the absence of signs of a resolution we would expect this dislocation to become greater and for the risk of market-based anxiety to deepen as we approach the X-date.
We cannot claim with any confidence that an agreement between the parties will be reached in time and what concessions President Biden may have to grant to get there. This is important, as in 2011 President Obama was forced to accept hefty reductions in public expenditure which if carried out now would further encourage market speculation of aggressive cuts in interest rates. As we have shown above, historical precedent does point toward the scenario of a last-minute deal. If this fails to happen our suspicion is that the authorities will attempt to deploy some forms of emergency measures close to those outlined above. These would potentially bring about a considerable degree of chaos but would avert the spectre of a formal default, at least for a while.
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