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May 12, 2023 | 13:18
U.S. Debt Limit: Once More to the Brink
Economics
Economics
Economics
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Economics
Fixed Income Strategy
Economics
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Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
U.S. Debt Limit: Once More to the Brink |
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It’s called ‘X-Date’. The day when Treasury’s extraordinary measures run out and its cash balance runs dry. It’s the moment when the U.S. government is no longer able to honour all financial obligations when they come due. It’s the point when America will eventually default on its debt, and it’s now expected to arrive in early June after Treasury Secretary Yellen’s notification to Congress on May 1—weeks before the previous projections and market expectations. X-Date can be avoided by lifting the debt limit. The $31.38 trillion ceiling was hit on January 19 with government finances living off extraordinary measures ever since (Chart 1). The debt limit can also be rescinded and reactivated later. The Biden Administration and Democrat-controlled Senate are demanding a ‘clean’ bill to lift the limit, one with no fiscal strings, such as spending cuts, attached. |
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For its part, the Republican-controlled House of Representatives has already passed a bill by a slim 217-to-215 majority (on April 26). It would raise the debt ceiling by $1.5 trillion or until March 31, 2024, whichever comes first. But there were plenty of fiscal strings attached in reducing the 10-year deficit by $4.8 trillion, including repealing marquee measures such as student debt relief and clean energy subsidies. The Senate won’t pass this bill and, even if it did, President Biden said he would veto it. Meanwhile, Senate Majority Leader Schumer (D) is expected to introduce a clean bill to lift the debt limit, which doesn’t stand a chance in the House. With the clock counting down, the two sides weren’t formally negotiating, let alone meeting, until this week. The President and four congressional leaders spoke on May 9, agreeing to meet again early next week (while their staffs dig into the details of a potential deal). With between zero and $4.8 trillion in 10-year cuts on the table, there would appear to be a wide chasm to close. Accelerated Expectations Another reason for the sudden urgency on the part of lawmakers likely has to do with many of them thinking they had more time before the clock strikes midnight. The CBO projections released back in February suggested that Treasury was likely to run out of cash sometime between July and September. Markets were still pricing mid-August as the likely X-Date as recently as late April, as illustrated by the spread between 3-month and 1-month T-bill rates (Chart 2). The rising premium on the 3-month in April lined up with an August X-Date, while the recent reversal now has traders more concerned about a default in early June. Also on May 1, the CBO similarly released new guidance to say that the odds of an early June X-Date had risen since its February estimate. |
The sudden X-Date flip-flop was telegraphed in advance by lower-than-expected tax receipts so far this year (Chart 3), due to the relatively light intake of nonwithheld individual income tax (i.e., capital gains taxes) in April. Both equity and fixed income markets had a tough year in 2022, which meant that come tax-time, individuals had fewer gains to report. That contrasts with withheld individual income taxes, which mirrored the resilience of nominal GDP growth. While it’s no surprise that those revenues came in below expectations, it constrains the timeline for lawmakers to find a solution. Adding Salt to the Wound No matter how you slice it, the United States faces tough choices to bring its fiscal house in order. However, further political brinkmanship—or even worse, failure to raise the debt limit—would be like adding salt to the wound. Recent studies, including one by the President’s own Council of Economics Advisers (CEA), have shown that the consequences of legislative inaction, or worse, default, could be dire (Table 1). If brinksmanship pushes the U.S. closer to X-date without a deal in place, then we’re more likely to see market stress indicators amplify. Table 1 summarizes the impacts on growth and employment of several debt limit scenarios considered in studies by Moody’s Analytics and the CEA. Not reaching a timely deal would initially weigh modestly on both employment and growth compared to a clean lift of the debt limit, with Moody’s indicating that it could lead to the President invoking the 14th Amendment (discussed later). Financial market stress would be the primary channel driving these effects. The macroeconomic consequences of a short default would be somewhat more severe, particularly if the threat of one forced Treasury to engage in payment prioritization (Moody’s). Growth would weaken, likely tipping the U.S. into a mild recession and jobless rates would rise by as much as 1 ppt. The range of the impacts depends on the immediate market reaction to a (probably temporary) credit rating downgrade. Under the assumption that any episode of missed payments was brief and fully cured, the lasting effects on the real economy would be more muted from a short default. However, if bondholders continue to demand a premium for Treasuries (even a few basis points), it would add significant cost to taxpayers in the form of future net interest obligations. |
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A prolonged default would have dire consequences for the U.S. (and likely global) economy. Financial markets would plummet, and the economy would fall into a sharp recession. The jobless rate could rise by as much as 5 ppts, bringing it above 8%, and real GDP could fall over 6%. With affordability already top of mind, rising credit spreads on business and consumer lending would significantly hamper new spending and investment, particularly in the most rate sensitive sectors of the economy (e.g., housing). The government’s inability to borrow would also rule out any fiscal response to cushion the blow. In addition to the financial and credit market turmoil, a prolonged default would put at risk the roughly $165 bln Treasury pays out each month for Social Security, Medicare, and activity duty military personnel. On an annual basis, that works out to over 7% of GDP. Both Moody’s and the CEA arrived at similarly severe economic consequences of a protracted default, underscoring that these are risks best avoided. A default-less X-Date As mentioned above, X-Date can be avoided by lifting or rescinding the debt limit, but there are also ways, at least in theory, that the government could keep making interest payments and avoid default, and also pay all or most of its remaining bills. The two most-mentioned workarounds are prioritization and invoking the 14th Amendment. Prioritization means paying debt holders first to avoid a default; then, dealing with all other obligations. Fed transcripts released five years after the 2011 debt ceiling crisis reveal that this was the strategy Treasury and the Fed came up with. Indeed, there’s already a House bill being considered to compel Treasury to do just that (it hasn’t had a floor vote yet). 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 to address the issue. The Federal Reserve Bank of New York has stated that it could potentially handle debt service payments, leaving Treasury to sort through the rest. 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 the next day. In fiscal 2022, after making interest payments, Treasury had a funding shortfall of $900 billion (the overall budget deficit was $1.4 trillion) meaning the ranks of the unpaid at the end of each day would swell over time (to the tune of about $2.5 billion, on average, per calendar day). Also swelling would be the lawsuits from businesses and individuals who aren’t getting paid, along with the ripple effects of the absent cash flow in the economy. Some legal scholars argue that Section 4 of the 14th Amendment (“The validity of the public debt of the United States… shall not be questioned”) makes it unconstitutional for an Administration not to make interest payments even if the debt limit is not lifted. Originally crafted to address concerns over some states hesitating about paying Civil War-related debts, this Amendment has never been invoked before (although it was mentioned during the 2013 debt limit impasse) and hasn’t been tested in the courts. President Biden said this week that he is “considering” invoking the 14th Amendment, with Secretary Yellen recently saying that using it would risk a “constitutional crisis”. Other less-touted X-Date workaround measures include selling assets such as gold and issuing IOUs (scrip) to cover unpaid or partially unpaid obligations. The IOUs would be honoured once the debt ceiling is raised, and some say a secondary market in IOUs would develop. Another is to mint a trillion-dollar platinum coin, building on the Administration’s authority to issue commemorative coins. This would be deposited in the government’s account at the Fed. However, Treasury Secretary (and former Fed Chair) Yellen has said the Fed is unlikely to accept such a coin. Finally, the President could simply ignore the debt ceiling citing a national emergency and allow the courts to sort it out. Whether it’s prioritization, the 14th Amendment or other workarounds, they all share a common feature in that they put on full display America’s fiscal paralysis, which will have implications for financial markets and economic prospects, not to mention the nation’s credit rating. Bottom Line: While raising the debt limit doesn’t solve the ongoing fiscal challenges of the U.S. government, failing to come to a timely agreement risks putting the economy through the ringer. At stake is the robust labour market recovery so far this cycle, and the significant benefit that Treasuries currently enjoy as a result of their unparalleled safety and liquidity. Although most still expect a default will be averted, the potential consequences suggest that if it comes to that point, untested workarounds may see the light of day. |