The Debt Ceiling—This Time is Different

The Current Standoff

The amount of allowable outstanding U.S. federal debt is currently set at $31.4 trillion, which the U.S. hit on January 19, 2023. The Department of Treasury has been using a series of accounting maneuvers to continue paying its bills, so the debt limit has not yet been binding. Off the back of April’s tax receipts and government outlays, Treasury Secretary Janet Yellen wrote in a letter on May 1 to House Speaker Kevin McCarthy that the U.S. government may be unable to meet its obligations as soon as June 1. The Treasury’s timeline was reinforced by the nonpartisan Congressional Budget Office (CBO), which warned that the Treasury will run out of funds in early June.

That a so-called “X date”—when the debt ceiling binds—looms is no surprise, but it is now going to hit much sooner than previously expected. Assuming they had more time to negotiate, politicians had been discussing the debt ceiling without urgency. That has now changed, with negotiations between President Joe Biden and the four bipartisan leaders of the House and the Senate happening in earnest.

While the leaders of the two congressional chambers and the president agree the U.S. must not reach the X date without lifting the debt ceiling, it is unclear how this will happen. From the outset, Republicans have demanded severe spending cuts in exchange for raising the debt ceiling. On April 26, the House narrowly passed a budget bill—the Limit, Save, Grow Act of 2023—that would roll back many of President Biden’s policy initiatives. It would scrap student loan forgiveness and funding for the Internal Revenue Service to improve tax collection, while slashing discretionary government spending. In return, the legislation would raise the debt limit by $1.5 trillion or until March 31, 2024 (whichever hits first), kicking the debt ceiling can down the road by less than a year and necessitating another likely debt ceiling showdown in an election year, when the standoff could be even more pronounced.

There is zero chance that the proposed Republican legislation will pass in the Senate. The Biden administration rightly argues that the debt ceiling is not related to spending going forward; debt is issued to pay the bills for spending that has already happened. If Republicans don’t like the government’s tax and spending policies, the argument goes, they should address this in the annual budget negotiations. The Democrats favor raising taxes on the wealthy and boosting tax collection rather than sharply cutting spending. The only area of overlap between the two parties is that Social Security and Medicare are off the table in these discussions.

The more imminent X date could result in a small increase in the debt limit to push negotiations out until the end of the fiscal year on September 30. This would mean the debt ceiling talks and negotiations to prevent a government shutdown would run concurrently. The risk is that there would be a simultaneous default on a payment and government shutdown. But shifting the talks to the end of the fiscal year would align them with the annual budget period, which is when tax and spending policy should be discussed. It may therefore open up some opportunities for horse trading so both parties agree to lift the debt ceiling for a longer period of time.

Clean Debt Limit Increase

A clean debt limit increase with few or no fiscal strings attached would be the least economically damaging way of ending the current standoff. History is a good guide for how this might work given the vast majority of the over 100 increases since World War II have been clean. After haggling for months, politicians usually come to agreement just in time before the X date binds and pass legislation to raise the debt limit without any major conditions. This allows Treasury to continue paying all its bills.

Under the best-case scenario, a clean debt limit increase this time would probably be large enough to cover expected spending into early 2025 to avoid having another debt limit standoff in the middle of the 2024 presidential election. If that happened, Treasury bill yields would rise for notes maturing just after the X date. There could also be a drop in equity markets leading up to the agreement. But once a clean debt limit deal is agreed, there would likely be no lasting implications for either the U.S. economy or financial markets.

Prioritization

If U.S. lawmakers are unable to agree to raise the debt ceiling before it is binding, then the U.S. will default on payments. Before the X date was moved forward to June, this seemed like the most likely scenario. Now that the X date is nigh, there is a chance—though by no means is it a foregone conclusion—legislators may agree on a short increase until the end of the fiscal year. As a result, the probability of the U.S. defaulting on a payment has fallen marginally but is still uncomfortably high at around 30%.

The Treasury Department devised a playbook in 2011 for how to respond if the U.S. defaults on a payment and the Biden administration is likely to dust this off and implement it if no deal is reached before the X date. Under this plan, interest payments on Treasury securities would be prioritized and maturing debt would be rolled over by auctioning new securities for the same amount (thereby not increasing the country’s debt burden). The U.S. would not default on its debt. Technically, this is possible as bond payments are handled by the Fedwire payment system while other government obligations are paid via a different computer system.

While avoiding a debt default could mitigate the impact on U.S. and global markets, it is not without problems. First, it would be politically toxic for the Biden administration to admit that it is paying off foreign bond investors while social security checks and teachers’ pay were being put on hold—particularly in the run-up to an election year. Second, there would inevitably be legal challenges. Given the legal uncertainty, bond investors would demand a much higher premium to hold U.S. debt and government borrowing costs would rise.

Once bondholders have been paid, it is unclear how all the other debt obligations would be prioritized. It seems likely that Treasury would delay all payments until it had enough cash to pay a full day’s obligations rather than picking and choosing who gets paid first. These other outlays would have to be cut by an average of 25% per month given the CBO expects roughly 25 cents of every dollar of non-interest outlays will be financed by borrowing this year. The cuts in federal spending would probably be even larger in July and August given tax revenues tend to be lower in these months.

The market response in this scenario is nearly impossible to predict given it is without precedent in the U.S. Investors might consider that the U.S. is defaulting on obligations because it won’t pay rather than because it can’t pay and might shrug off missed payments initially. Alternatively, the same logic could push investors to consider the U.S. political system so completely dysfunctional that they demand a much higher premium for buying U.S. debt, structurally increasing U.S. borrowing costs. Some research suggests that the unparalleled safety and liquidity of the U.S. Treasury market lowers the interest rate on government bonds (relative to that of other government bonds) by roughly 25 basis points. This adds up to over $750 bn over the next decade. Any loss of this advantage would result in substantial costs for the taxpayer.

How markets and the economy respond depends in part on how long it takes for the government to raise the debt ceiling and make everyone whole. Even if the debt ceiling were only briefly binding, there would probably be lasting implications. Investors would consider that they may not get paid what they are due when it is due and so would anticipate these disruptions every time the debt limit approaches. This would drive up the risk premium and U.S. government borrowing costs would be structurally higher. Household and business confidence would plummet and take some time to rebound. The market reaction could be severe, pushing an already fragile economy into recession.

In 2013, the Federal Reserve estimated that if the debt ceiling binds for one month, 10-year Treasury yields would rise by 80 basis points, stock prices would fall 30% and the value of the dollar would drop 10%. This would cause the U.S. to import inflationary pressures from abroad at a time when domestic inflation is already too high. According to analysis from the CEA, a short failure to pay obligations would wipe out half a million jobs, push up unemployment by 0.3% and eliminate 0.6 percentage points from GDP growth.

The implications would be much worse if the default lasted longer. The CEA estimates that a binding debt ceiling for a full quarter would send the stock market sinking by 45% while GDP would fall by 6.1 percentage points, 8.3 million jobs would be lost and unemployment would rise by 5 percentage points. According to Moody’s Analytics, a debt ceiling that binds for an extended period would shave 4 percentage points off of growth, eliminate 7 million jobs, push unemployment above 8%, send stocks falling by nearly 20% and cause all public and private sector bond yields to spike. These estimates differ, but they are all dire.

The Federal Reserve would cut interest rates in this scenario, but the Treasury department would be unable to provide countercyclical fiscal measures given its inability to borrow. On the contrary, it would have to slash its spending, making the recession even worse.

The U.S. could face additional credit ratings downgrades. Fitch has indicated that prioritizing debt payments to avoid an immediate default might not be consistent with a “AAA” rating. Countries that are stripped of their “AAA” status typically see their cost of funding go up. Business loans and other corporate debt instruments are typically priced as a spread over U.S Treasuries. An increase in the cost of funding for the U.S. government would place further upward pressure on the cost of debt faced by businesses, which for investment-grade companies already stands at similar levels to 2009. This scenario would see bankruptcies and restructuring rise and M&A activity would suffer significantly. Valuations would need to be revised down along with growth and inflation forecasts.

Federal Reserve Steps In

At his latest press conference, Chair Jerome Powell insisted that the Fed is unlikely to be able to protect the U.S. economy from the damage prompted by a binding debt ceiling. However, this isn’t strictly true. The Fed could temporarily restart quantitative easing (QE) by buying Treasuries, as the Bank of England did last September when UK government bond yields spiked. If a default pushed short-term rates up, the Fed could expand its standing repo facility. If demand for un-defaulted government securities pushed their yields too low, the Fed could lend Treasuries to the market via reverse repos.

The central bank could also accept defaulted Treasuries as collateral or buy them outright, an option Chair Jay Powell called “loathsome” on a Fed conference call in 2013. Hoovering up defaulted securities would almost certainly be met with lawsuits and could increase inflation when it is still too high. The Fed will also be wary of creating moral hazard by bailing out politicians dithering on lifting the debt ceiling.

So far, the market reaction to a potentially binding debt ceiling has been perceptible but relatively muted. This will change as the X date approaches, and ultimately that may be a good thing. Politicians often posture until they face an emergency so dire that they have to make a decision. Market discipline will probably be necessary to prompt such an emergency. There are a number of scenarios that involve the U.S. avoiding a debt default. But even the political brinkmanship we are already witnessing on the debt ceiling will have macroeconomic and market impacts. A more imminent X date suggests that an agreement to raise the debt ceiling until the end of the fiscal year could be struck. This should provide opportunities for a real discussion about budget discipline, which otherwise would be inappropriate to attach to the debt ceiling. Even if a worst-case scenario is avoided, any drag on output in this environment of weak growth is unwelcome. If the X date binds, the implications for markets and for our clients will depend on which payments are missed and for how long. We are confident everyone will be made whole in the end, but the loss in confidence and wealth that could result if the U.S. defaults will have lasting effects on the economy.

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^1.Denmark also has a debt ceiling, but it has never been used in political brinkmanship.