By now, you’ve heard a lot about the fight in Washington over the debt ceiling, and the potential consequences for the economy should Congress and the White House not reach a deal. And we know you’re concerned — there’s a reason why the debt ceiling was the big topic of conversation at our InvestingFixx investing club this week.
But what is the debt ceiling, really, and why is this topic such a big (and important!) one?
What is the debt ceiling?
According to the United States Treasury Department, the debt limit (or ceiling) is “the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments.”
In other words, it’s our country’s credit limit. And we’re about to max out.
So, wouldn’t cutting spending solve the problem?
In the long term, yes. But it does nothing for us in the short term, which is the pressing concern. Cutting spending could conceivably help avoid this brinksmanship (i.e. ridiculous back and forth) in the future (as would raising revenue) but the key point often lost in the whole debt ceiling discussion is that raising the limit only allows the U.S. to pay the bills for which it has already budgeted payment — only it did it without actually having the cash on hand to make those payments.
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Make sense? Here’s an explainer using a personal budget as a reference: Let’s say you have $10,000 in your checking account. You write a check for $15,000 and then quickly ask your bank to loan you $5,000. But you’ve already “spent” the money, so if the bank says no, your check bounces and you default on your purchase and mess up your credit rating.
That’s how government spending works. First, they vote to spend and then they okay borrowing the additional funds, so the checks don’t bounce. (No, you shouldn’t manage your household budget like this!)
When did these debt limit issues begin?
The debt ceiling didn’t exist until 1917, when the U.S. allowed the Treasury to raise funds (mostly through bonds), without prior congressional approval, to help pay for World War I. The debt limit then was only $11.5 billion. Today, $11.5 billion is pocket change. Congress established the first of the Public Debt Acts in 1939, and in 1941 raised the debt limit to $65 billion. It was repeatedly raised throughout the 1940s.
In 1979, Missouri Congressman Dick Gephardt put forth the “Gephardt Rule,” which automatically raised the debt ceiling when the budget was passed. The Republican congressional majority that came to power in 1994 repealed the Gephardt Rule and refused to raise the debt ceiling in order to get budget cuts from President Clinton. This high-stakes game of chicken led to two government shutdowns between November 1995 and January 1996.
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The first time the government shut down was in 1976, and it’s happened 21 times since then — usually for just a day. A few of the shutdowns have been related to the debt ceiling, the others were related to Congress’s inability to approve appropriations (spending) bills. But it’s always about money. Since John F. Kennedy was president, Congress has acted 78 separate times to raise, extend, or redefine the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents – 18 times just during the two terms of President Reagan. The debt ceiling has never been lowered, but the U.S. does occasionally pay off debt.
Where does the debt ceiling stand now?
The debt ceiling jumped from $125 billion to $300 billion during World War II. It crossed the $1 trillion mark under Reagan in 1981. Under George W. Bush in 2008, it crossed the $10 trillion mark. Eleven years later, under Donald Trump, the $20 trillion barrier was smashed. Due to pandemic spending to try to avoid a major recession, the debt limit is now over $31 trillion.
Okay, but what does the debt ceiling mean for investors?
The exact impact on investors if the U.S. defaults is unknown, says Daleep Singh, Chief Global Economist and Head of Global Macroeconomic Research at PGIM Fixed Income. “It’s difficult to make predictions since it has never happened before. However, it is safe to say that the uncertainty alone of a default would crush equities and credit markets. This could mean major disruptions to the plumbing of the global financial system that liquifies the global economy.”
In other words, it could be very, very bad. And there are broader implications that go beyond the markets. The current strength of the dollar allows American households, businesses, and governments at all levels to fund themselves far more cheaply than would otherwise be the case, Singh explains. Families benefit from the dollar’s unrivaled status each day by paying lower interest rates on credit card debt, mortgages, and student loans. This would all disappear if the dollar lost its primacy, which could very well happen if we default. (The primacy of the dollar is based on it being the currency all others are measured against. The Council for Foreign Relations refers to the dollar as “the world’s currency.” And it’s good for our economy for us to keep it that way.)
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“There are also crucial foreign policy implications,” Singh says. “The United States is currently spearheading the most severe economic sanctions campaign in history against Russia, which in large part is driven by our ability to exclude Russia from the dollar-dominated global financial system. If the dollar loses its primacy, this could very well affect Washington’s ability to employ a harsher sanctions campaign. This ongoing battle is very serious and if we default, there is a lot at stake.”
The dollar’s primacy, Singh adds, is rooted in trust, but all systems based on trust have tipping points. “Dollar primacy was able to gather force over the past century mainly thanks to faith in the United States’ control of the global financial system. If trust in the U.S. government’s ability to pay its bills falters, the competitive strength that the U.S. holds will also lose value.”
So, as we move toward the make-or-break decision date with the debt ceiling, are stocks or bonds more likely to be hit harder?
Both treasury bonds and stocks would be affected, says Singh. “For investors looking at risky assets like equities and credit markets, I see a lot of downside from here. [When it comes to short-term bills and risk-free assets out the curve, there will be a sizable economic effect if we go anywhere near the ‘X date’, which will likely be between early June and early August.] However, it’s important to highlight that this is a venture into the unknown and we don’t know what the exact effects will be, including to assets that we normally think of as risk- free.”
Okay, I get it… But will this partisan battle actually take the U.S. to the brink?
For politicians on both sides of the aisle, it would be best for a new deal to be reached quickly, so an economy that may already be headed toward a recession isn’t forced into something far, far worse. Karen Finerman, CEO of Metropolitan Capital Advisors and co-founder of HerMoney’s InvestingFixx investing club for women offered some insight into the most likely possible outcomes of the debt ceiling negotiations, which she ranked from most likely to happen to least likely to happen:
1) There will be a debt ceiling deal by early June, in time to avert a crisis.
2) Treasury Secretary Janet Yellen will find a way to extend the deadline to allow time for a deal to be finalized without causing a crisis.
3) Yellen will find a way to extend the deadline while a negotiation proceeds, but the timing for a deal will remain unclear.
4) President Biden will agree to budget cuts at the 11th hour after Yellen has exhausted all efforts to extend the deadline.
5) There’s no deal. The U.S. defaults on its debt for a very short period of time because the markets go down and people freak out. (Ironically, in this scenario people will buy U.S. longer -dated Treasury bonds as they will still be considered the world’s safest investment.)
6) The U.S. defaults for an extended amount of time — an almost unimaginable outcome.
Here’s hoping for #1.
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