January 27, 2023 | 13:25
America’s Debt Limit Drama
America’s Debt Limit Drama
The U.S. reached its $31.38 trillion debt limit on January 19. The debt limit places a statutory maximum on the amount of money that Treasury may borrow to fund federal operations (often referred to as the “debt ceiling”). It’s worth pointing out that the debt ceiling doesn’t control the amount of new spending. It is an after-the-fact measure that constricts Treasury’s ability to borrow to pay for the decisions already enacted by Congress and the President. Hence, when the debt limit was reached net new debt could no longer be issued despite being required to finance the shortfall between receipts and outlays. As such, “extraordinary measures” began. These measures allow net new marketable debt to continue being issued without increasing total debt (see the appendix, “Extraordinary Measures”). Many of the available options amount to suspending investments in federal employee retirement funds.
However, these measures are not unlimited; and when they run out, Treasury will no longer have the resources to cover its net obligations including interest payments on debt outstanding. This would put the U.S. government in default. In the past, such “extraordinary measures” have delayed required action on the debt limit from periods ranging from a few weeks to several months. Hence, when this so-called “X Date” occurs cannot be determined with precision given the uncertainty surrounding the exact timing of daily receipts and outlays. Treasury Secretary Yellen informed Congress that the current X Date was estimated to be June 5. That being said, at least $140 bln of the potential extraordinary measures won’t be available until June 30. Between now and then, legislation to either lift or suspend the debt ceiling must be passed, as we begin yet another episode of America’s debt limit drama.
When the debt limit is lifted by a specific amount, Congress has two things in mind. The first is the projected cumulative budget deficit that must be financed (based on a budget or continuing resolution which Congress has already approved). The second is the preferred timing of the next debate about lifting the limit. Each time the debt ceiling is raised, the consequent large gap with debt outstanding starts to steadily narrow, eventually necessitating a need to raise it again (Chart 1). Suspending the debt limit (for a specific period) means that Treasury can issue any amount of debt but under a constraint that its cash balance at the end of suspension must be the same as it was at the beginning, so no pre-financing is allowed before the debt limit is reactivated. The new, higher debt ceiling is set at the current level of debt outstanding (also for a specific period) meaning that the limit is immediately hit and must be raised or suspended again.
Past Seasons’ Synopsis
Congress has the ‘power of the purse’ and legislates the U.S. government’s receipts and outlays. Separately, and since 1939, Congress has legislated the total amount of debt that can be issued to finance the implied shortfalls. Although the notion of a separately approved debt limit was designed to act as a sort of check on the already approved paths for receipts and outlays, it was treated more as a rubber-stamping exercise for four decades. There was no drama.
Then, in April 1979, an impasse over the budget delayed the subsequent lifting of the debt limit, and it went down to the wire for the first time… to within days of default (extraordinary measures weren’t used back then). To help avoid a repeat situation, legislation was then passed to combine the approval of the budget and debt limit into one vote. But this kept the limit’s lifting at the mercy of the budget approval process and congressional members looking to alter the course of fiscal policy. In September 1985, another budget impasse (the outcome being the famous Gramm-Rudman-Hollings deficit reduction law) led to the debt limit being hit and Treasury unilaterally (without Congressional approval) using extraordinary measures for the first time to avoid default. A year later, Congress approved Treasury’s use of such measures. The debt limit was hit, and extraordinary measures were implemented several other times after that, including in 1995-1996, 2002, 2003, 2004 and 2006.
Congress repealed the one-vote legislation in 2011, which is when the next episode occurred and this one went down to the wire. The situation prompted S&P to downgrade the U.S. government’s credit rating. Afterwards, the debt limit was hit, and extraordinary measures were implemented in 2013 (began late 2012), 2015, 2017 (ended early 2018) and 2019. Given the frequency of these episodes, particularly since 2011, the market has probably become somewhat accustomed to them. However, there is a bit more buzz this time about the potential for it going down to the wire (shades of 2011) or worse, given the current rancour in Congress.
There is always a degree of brinkmanship with a divided Congress, but the last major episode around the debt ceiling, as mentioned above, was in 2011. The Republicans took control of the House and threatened not to extend the debt limit unless President Obama and Democrats agreed to cut program spending. The resulting Budget Control Act ultimately led to around $1.3 trillion in reduced spending over a decade (roughly 8.2% of GDP at the time or 0.8% of GDP per year).
That drama exacted its toll on the economy, particularly for financial markets. They were still recovering from the global financial crisis and were more susceptible to volatility. The S&P 500 dropped 17% in the period around the debt limit debate and didn’t recover to its average over the first half of 2011 until 2012 (Chart 2). In addition to the price effects, volatility also increased, with the daily average of the VIX pushing above 30 in the last five months of the year compared to 18 in the first half of 2011. This is highlighted by all the head fakes that took place from April through to the end of July until an agreement to lift the debt ceiling was reached. The agreement wasn’t enough to prevent S&P from downgrading the U.S. credit rating on August 5 of that year, which likely contributed to the protracted weakness in markets. Credit spreads also widened with corporate BBB spreads jumping 56 basis points and remaining elevated into 2012. Additionally, households also felt further pressure from the brinkmanship as spreads on conventional mortgages widened by as much as 70 bps. That may have spilled over into consumer confidence as it fell 22% at the time and took months to fully recover.
Amid this, Treasuries were no worse for wear, as the European sovereign debt crisis helped push down Treasury yields at the time (Chart 3). Given that the USD accounts for the lion’s share of global reserves (roughly 60%), in times of greater uncertainty, global flows toward safer assets help lead to a rally in Treasuries. With elevated geopolitical risk and the slowing global economy at play this time around, we could see a similar pattern play out if brinkmanship pushes Congress to another debt limit dilemma.
Given the real consequences that political drama can have on the economy, did this episode achieve its alleged objective of controlling government spending? The answer is fuzzy at best (Chart 4). Spending (as a percent of GDP) soared at the beginning of 2009 as the U.S. government rolled out temporary fiscal measures to support the economy. As those measures faded and the economy recovered, spending eventually fell to around 20% of GDP. The Budget Control Act likely contributed to that path, but pales in comparison to the cuts to defense spending and welfare that took place in the 1990s alongside a strong economy that boosted revenues. The lesson being that last-minute debt drama isn’t a replacement for more sober consideration of fiscal restraint.
History often rhymes, and one has to acknowledge there are some similarities between 2011 and now. For one, pandemic-related spending led to an even larger surge in government spending than in the financial crisis. Second, there is a similar wave of anger around economic developments, although this time over inflation. Those factors likely helped propel Republicans to take a narrow (9-seat) lead in the House in November (in 2011 they held a 49-seat majority) and leave them poised to attempt a similar sortie come June. Partisanship has also become further amplified in the meantime and Speaker McCarthy has to deliver on the spending and debt ceiling promises he made to secure his speakership, raising the risks of reaching X date.
On X Date
If Congress fails to lift or suspend the debt limit and extraordinary measures are running out, there have been several proposals made since 2011 on how to avoid X Date. These include selling assets such as gold (Treasury has said there won’t be any ‘fire sales’) and invoking the 14th Amendment which some argue give the President the power to issue debt (“The validity of the public debt of the United States… shall not be questioned.”). Another is to issue IOUs (scrip) to cover unpaid or partially unpaid obligations. The IOUs would be honoured once the debt ceiling stops being an issue and some say a secondary market in IOUs would develop (California issued IOUs during one of its past budget crises). Yet another is to mint a trillion-dollar platinum coin to be deposited in the government’s account at the Fed. Treasury Secretary (and former Fed Chair) Yellen said recently that the Fed wouldn’t accept such a coin.
These proposals have been deemed impractical and, instead, the focus has been on how to avoid default on U.S. Treasury securities after X Date by prioritizing payments. Fed transcripts released five years after 2011 reveal that this was the strategy Treasury and the Fed came up with; essentially to pay bondholders first. Indeed, as it has in the past, Congress is currently crafting legislation to compel Treasury to do just that.
For Treasury, picking and choosing which obligations to pay each day would be problematic given that there are over 80 million payments per month; and, it’s debatable whether Treasury’s accounting system is robust enough. The Federal Reserve of New York has stated that it could potentially handle debt service payments, presumably leaving Treasury the task of prioritizing all other payments. According to government studies after 2011, the only practical way to do this would be to pay invoices and other obligations with remaining funds as they are received. Those unpaid by the end of the day would move to the front of the line for next day (which is still a form of ‘default’). But with Treasury running a trillion-dollar (plus) budget deficit, the ranks of the unpaid at the end of each day would swell over time. So too would the lawsuits from businesses and individuals who aren’t getting paid. And what if these disgruntled vendors and benefit recipients won their cases, could this undermine prioritization?
Besides, how would investors react to such an unprecedented display of fiscal paralysis? Could this mean persistently higher yields this time, unlike 2011? After all, it was the risk of reaching X Date that compelled S&P to downgrade the U.S. government that year. In the event of potential downgrades, some investors would no longer be able to invest in Treasuries, applying upward pressure on yields. Then there’s also the economic impacts of reduced investor, business and consumer confidence, along with the ripple effects of businesses and individuals not getting paid. Even if technical default doesn’t occur, the economic costs would still likely be meaningful. The added uncertainty from geopolitical risks and China's reopening, could amplify market turbulence related to the debt limit brinkmanship in the meantime. There is unanimity among analysts that X Date is best avoided.
Appendix: Extraordinary Measures
Potential Headroom Savings through June 2023
Civil Service Retirement and Disability Fund (CRSDF) and Postal Service Retiree Health Benefits Fund (PSRHBF)
Declaring a debt issuance suspension period related to these two retirement funds and on June 30, 2023, redeeming investments in the CSRDF and PSRHBF that will mature along with their interest payments.
Government Securities Investment Fund (G Fund)
Suspending daily reinvestment of all or part of the balance of Treasury securities held by the G Fund of the Federal Employees’ Retirement System Thrift Savings Plan.
Exchange Stabilization Fund (ESF)
The USD portion of the ESF is invested in special-issue Treasury securities, which don’t count against the debt limit. The entire USD balance matures daily and Treasury can suspend investment to create debt limit headroom.
State and Local Government Series Securities (SLGS)
SLGS are special-purpose securities used to assist state and local governments to comply with Federal tax laws, but these can be suspended. The monthly amounts can be volatile.