By Jeremy Wallace and Andrew Hart
“Here we go again.” That’s a line from Return of the Jedi, delivered by C-3PO just before he and his friends prepare to go out on another harrowing adventure. In the movie, poor 3PO was referring to taking down the Death Star, but he could have easily been referring to something else:
The Debt Ceiling.
Yes, it’s back. And now, economists, pundits, politicians, and investors are all saying the same thing: “Here we go again.”
On January 19, the United States officially hit the debt ceiling.1 Now, you probably didn’t notice anything different when you woke up that morning, and nor will you for a while. But there is a chance that sometime this year, the effects will be very noticeable indeed. This is a story that will likely dominate the news more and more in the coming months. Furthermore, it may lead to volatility in the markets. So, to help prepare you for the spate of headlines coming our way, here’s a quick preview on the debt ceiling fight brewing in Washington.
First, let’s recap what the debt ceiling actually is. Many people think the debt ceiling is a cap on how much total money our government can spend, but it’s not. This is actually an important point. In truth, the debt ceiling is “the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations.”1
Now, what are these obligations? It’s a massive list, including everything from Social Security and Medicare benefits to tax refunds, military salaries, and interest payments on Treasury bonds. The debt ceiling, then, is the limit to what the government can borrow to pay back what it has already spent. (Or is legally obligated to spend.)
Normally, raising the debt ceiling requires a simple act of Congress. Some years, however, politicians in Congress disagree about whether the ceiling should be raised. Or, if the ceiling should only be raised if it also comes with a decrease in government spending. When this happens, we get a debt ceiling crisis, where the nation comes perilously close to defaulting on its debts. The most nerve-racking of these crises occurred in 2011. Back then, the U.S. came so close to a default, our nation’s credit rating was downgraded for the first time in history. (More on that in a moment.)
Unless things change very quickly, 2023 is setting up to be the most bare-knuckled fight since then. Now, for all our sakes, I’m going to skip the political aspects of this and focus solely on the financial. The most important being: What happens if the U.S. defaults on its debt?
The short answer: Nobody knows. It’s never happened before.
The long answer: Nobody knows for sure, but we have a good idea. It isn’t pretty.
For starters, seniors could stop receiving Social Security payments, or at least experience delays. Families could stop receiving Child Tax Credit Payments. Members of the US military would stop receiving paychecks, as would federal employees. Veterans’ benefits would be delayed. Food assistance for the hungry, homeless, poor, and malnourished could stop. Medicare patients would have no means of getting healthcare. You get the idea.
Less gut-wrenching on a human level, but equally impactful on a financial, is what a default would mean for the bond market. As you know, the U.S. issues Treasury bonds to pay for everything that taxes alone cannot. In a default, bondholders would no longer be paid, and the value of their bonds would plummet. This would lead to dramatically higher interest rates on any new debt issued in the future – which in turn would lead to higher rates for everyone. Given that rates are already higher than they’ve been in years, this would likely plunge the economy into a deep recession. And since Treasury bonds are historically the most stable investment in the world, it would probably disrupt international bond markets, too. The result? A global recession.
Now, there are some possible steps the government could take to diminish the effects of a default. The most likely option would be for the government to prioritize its debt payments. In this scenario, bondholders would get paid first, since they literally own the country’s debt. That might stabilize the bond market, but it could still lead to higher unemployment, lower consumer spending, and other problems. In other words, still a recession.
Another possibility would be for the Federal Reserve to buy a portion of those bonds so that bondholders aren’t left out in the cold. But doing this would also increase the nation’s money supply, leading to lower interest rates and higher inflation. That’s the very opposite of what the Fed is currently trying to do!
Other scenarios are either more far-fetched or come with a host of potential legal problems. For example, some academics argue that President Biden could simply ignore the debt ceiling. Other experts think this would be unconstitutional. If the courts agreed with that interpretation, all payments the government makes after breaching the debt ceiling would be considered invalid. This would also throw the bond market into turmoil. For these reasons, most policymakers usually see raising the debt ceiling as the only viable option.
At this point, you’re probably wondering why none of this has happened yet if we’ve technically already reached the debt ceiling. I can give you the answer in two words: Extraordinary Measures.
Now, let me give you the answer in a few more words. These “extraordinary measures” are basically accounting tools that help the government pay its bills without authorizing new debt. The good news is that these measures buy the government time. The bad news is that it’s just like replacing a flat tire with a spare one. It’ll get your car to the shop, but sooner or later, you’ll have to get a new tire.
As far as the debt ceiling is concerned, no one is exactly sure when “sooner or later will be.” In a recent letter to Congress, the Treasury Department estimated the clock will hit zero no earlier than June.1 So, the immediate question we need to ponder is what will happen before then.
Up to this point, the markets have been fairly calm about the debt ceiling. There are two reasons for this. The first reason is that, right now, investors are more concerned about things like interest rates and inflation. The second reason is due to the assumption that Washington will get its act together and raise the debt ceiling like it always has before.
Whether this happens remains to be seen. But, while history suggests the country will avoid a default, history also suggests the markets will get increasingly nervous the closer we get to the June deadline. For proof of that, let’s rewind back to 2011.
Back then, President Obama and House Republicans were locked in a fierce debate over the same issues Washington faces today. As the clock got closer to zero, Wall Street began to truly come to grips with the possibility of a default. At one point, things looked so dire that one of the major rating agencies actually downgraded the nation’s credit for the first time in history. It didn’t last very long, but it certainly rattled investors. The stock market fell sharply while the cost of borrowing rose. The only upside was that these effects shocked Washington into action, and a deal was cut to raise the debt ceiling mere days before a potential default.
For these reasons, my team and I are carefully watching the negotiations going on in the White House and on Capitol Hill. For the moment, we don’t see a need to make major changes to your portfolio. And we certainly don’t think you need to feel any stress about the subject right now. However, should anything change, we will let you know immediately. Furthermore, we’ll keep you up to date about the situation as we get closer to June. While Congress may be in the habit of waiting to the last minute to get things done, that’s not how we work here at Wallace Hart. We are committed to being vigilant and proactive as the months go by.
In the meantime, we’ll continue to monitor your investments daily. It’s our job to stress about the markets so that you don’t have to! Of course, please let me know if you ever have any questions, concerns, or just want to chat. Because, while the Force may not be real, I can still give you my own version of another famous Star Wars quote: “Remember, my team and I will be with you…always.”
Jeremy Wallace Andrew Hart
1 “Letter to the Speaker of the House,” Department of the Treasury, January 13, 2023. https://home.treasury.gov/system/files/136/Debt-Limit-Letter-to-Congress-McCarthy-20230113.pdf