Back in the 1980’s, Lionel Richie was a thing. After a successful career in the 70’s with the Commodores, Richie embarked on a solo career that brought multiple number one albums and singles, including the single “Hello”, which has one of the funniest/creepiest music videos of all-time (trust us, it is best watched for any description will not do it justice and would likely be flagged by someone in HR). Richie’s peak was reached (in our view) in 1986 with the album “Dancing on the Ceiling”, which spawned the number one hit single and Oscar nominee – “Say you, Say me” - and the eponymous single “Dancing on the Ceiling”, which described the incredible feelings one can have when they dance on the ceiling (in the 80’s, anything was possible). It also provides our segue into the topic du jour of this week’s missive.
If you watch cable news - either accidentally or on purpose - you have probably heard that the U.S. is running out of time to raise the debt ceiling. Let’s first start with what the debt ceiling is (spoiler alert, it is a galactically stupid construct) and then get into what it means and what is likely to happen.
The Debt Ceiling: The U.S. Constitution specifically authorizes Congress to borrow money against the credit of the United States. However, the problem with this is that essentially every time the U.S. needs to borrow money, Congress would need to specifically authorize the new debt. To get around this and because of the extensive borrowing needs associated with World War I and II, Congress established a limit that could be borrowed, which essentially created a credit line (debt ceiling) that could be used until the limit was reached. Once the limit was reached, the credit line would need to be increased or the specific new debt issued would need to be approved, thus keeping within the parameters laid out in the Constitution.
Now, it is important to note that the debt ceiling does not in any way authorize new spending. Rather, it essentially acts to pay for spending that has already been approved in a prior budget or spending act. The analogy would be that you have a credit card from the bank with a limit of $30,000. You purchase a new dishwasher for $2,000 and use the credit card for the purchase. The credit card had no say in the purchase, but rather was the instrument you used to complete the purchase. In the same way, the credit line authorized by Congress is simply the instrument to complete the purchase – it has no say in the actual purchase that was made.
Congress has authorized a lot of spending: Congress approved a budget in late 2022 that authorizes ~$5.8 trillion of spending in 2023. Tax receipts are expected to be ~$4.6 trillion, meaning the U.S. planned to run a deficit of ~$1.2 trillion for 2023. Now, we won’t get into the discussion of whether running a deficit of $1.2 trillion is a good or a bad thing, but rather focus on the fact that the credit line is going to be needed to fund this shortfall. The debt limit was last increased in late 2021 by $2.5 trillion, but between 2021’s remaining deficit, 2022’s deficit (~$1.2 trillion), and now 2023’s deficit, the $2.5 trillion has essentially run out.
Extraordinary Measures: Because the debt limit has been reached, the U.S. Treasury has been forced to use what are called “extraordinary measures”. This essentially means that the Treasury is using various accounting tricks to extend the life of the debt limit for as long as it can. However, these accounting tricks can only go so far, so at some point this summer, the debt limit will be reached, and all extraordinary measures will be exhausted.
The Republican Position: The GOP’s argument is that spending and deficits are out of control and unsustainable in the long run. Let’s look at a chart and then continue:
Thus, for them to agree to an increase in the debt ceiling, the GOP is demanding that certain concessions need to be granted, which basically entails a sharp decrease in spending to bring deficits under control in the long run. This week, the Republican-controlled House of Representatives approved a $1.5 trillion increase in the debt limit that was predicated on returning annual spending to 2022 levels and then capping annual increases at 1%. While this does not sound like a big ask, it would essentially nullify the 2022 Inflation Reduction Act, which is a signature piece of legislation for the Biden Administration and given the levels of inflation that we are currently dealing with, 1% annual spending increases essentially amounts to annual cuts in the 1-3% range. It is also worth noting that the Republican bill would essentially extend the limit into early/mid 2024, which is also an Election Year, meaning this issue would pop up just ahead of Election Day.
A couple of other things we would add that are important:
- The House of Representatives is very narrowly divided, so the Republicans cannot really lose any votes and hope to get legislation passed along party lines.
- Speaker Kevin McCarthy was barely elected in January and thus has a very tenuous hold on the Speakership.
The Democrat Position: The Democrats’ basic argument is that the debt limit should be raised without tying it to anything else. This so called “clean debt ceiling bill” is predicated on the idea that spending and deficits are separate decisions that Congress has already agreed to and tying the debt ceiling to prior legislation is fodder. Further, the Democrats argue that the GOP has never hesitated to raise the debt ceiling when there is a Republican in the White House and the Democrats do not make raising the debt ceiling an issue when they do not hold the White House. Thus, they essentially refuse to negotiate on anything other than raising the debt ceiling without any conditions, which is the same thing they do when a Republican is in the White House.
What happens if the debt ceiling is not raised? If the U.S. does not increase its credit line and the Treasury runs out of extraordinary measures, the U.S. would no longer be able to increase the amount of outstanding debt. This would essentially mean two things: 1) there may not be enough money to rollover existing debt and thus the U.S. would potentially have to default on government bonds maturing in the near-term; 2) the U.S. would have to stop paying certain bills – social security, Medicare, etc. – as they would have nothing left on the credit line to cover these expenditures.
It is worth noting that the U.S. almost got there in 2011, when a newly elected Republican Congress refused to raise the debt ceiling unless then President Obama negotiated spending cuts. Financial markets went into a tailspin prior to the U.S. reaching the limit and in the final hours, President Obama and Republicans agreed to increase the limit and to dramatic spending cuts. Markets quickly recovered; however, the event left scars on the Democrats, who again see this as an issue that the Republicans only seem to care about when a Democrat is in the White House.
What is likely to happen? The easy thing to say would be that the two sides will step back from the precipice and the debt ceiling will be increased. However, given the two sides are as divided as they have ever been and considering the tenuous hold the Republicans and Speaker McCarthy have on the House, the risks of not finding a resolution are probably higher than they have been since the 2011 episode. Further, the public mostly does not understand the debt ceiling issue, which makes the Democrats look bad since their – refuse to negotiate anything but a clean bill – stance looks like stubbornness when it may actually be the more righteous stance.
We would add that the Treasury did create a gameplan for this contingency back in 2011 and we would guess that they will use that plan should they need to in the current situation. Under this plan, the Treasury would continue to pay interest on Treasury securities as the interest came due. Further, as securities mature, the Treasury would pay that principal by issuing new securities for the same amount – thus not increasing the amount of debt outstanding. Concurrently, the Treasury would delay payments for all other obligations until it had at least enough cash on hand to pay a full day’s obligations. In other words, it would delay payments to agencies, contractors, Social Security beneficiaries, and Medicare providers rather than attempting to pick and choose which payments to make that are due on a given day.
While the above plan would avoid a default on any debt, it would cause a serious economic slowdown as many government programs would cease to function properly. Further, animal spirits (how the public feels about things), which are vital to the proper function of the economy, would likely take a serious hit, which would further the economic pain.
We would also add that the above plan lacks any specific Congressional authorization and thus would likely touch off a firestorm of lawsuits as the Treasury’s decision to prioritize certain expenses – interest payments – over others would likely lead to a legal hornet’s nest of issues.
Are there any loopholes? Some have suggested that Treasury could essentially mint a “trillion dollar coin” and deposit it at the Federal Reserve in exchange for cash to pay bills. Others have contended that the 14th Amendment, which ostensibly states that the validity of the public debt shall not be questioned, empowers the Treasury to avoid default no matter what Congress does or does not do, so the debt ceiling could simply be ignored. We have no opinion on these solutions; although, we do like picturing Treasury Secretary Yellen showing up at the Federal Reserve with a giant trillion dollar coin.
What would the impact be on markets? If 2011 is any indication – not good. The S&P 500 lost ~17% in the run-up to the 2011 crisis; although, it is worth noting that it recovered all of its losses and then some by early the following year. Obviously, the longer the crisis drags on, the larger the impact would be. We would note that the crisis would be unlikely to drag on for very long as usually financial chaos is the impetus for one or both sides to “blink” and to take action.
Final Thoughts: We generally think that cooler heads will prevail in situations such as this and that a resolution will be found in the 11th hour. However, given the toxic political climate in the U.S. and the difficulty in the Republican party finding common ground given its fractured nature, we would not be surprised to see this come down to the 59th minute of the 11th hour, or even cross the proverbial Rubicon for a period of time. As such, we remain generally cautious; although, we are interested to see whether the lead up to this crisis triggers some opportunities (never waste a good crisis) as markets will tend to throw the good out with the bad in times of distress.