The Independent Market Observer

Will the Debt Ceiling Debate End in Default?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Apr 21, 2023 3:18:03 PM

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debt ceiling

Recently, we have talked about a bunch of headline issues that are not real problems. Today, I want to discuss something that could be a real problem: the pending debt ceiling confrontation. This issue is one we need to understand and pay attention to. But as we will see, once again, it is also likely that the outcomes won’t be nearly as bad as the headlines suggest. It is something to watch but not something to panic about. 

Several months ago, the U.S. borrowed as much as it legally could. (I originally wrote this post then, back in January 2023, but have updated it here with the latest information.) Since then, it has not been allowed to borrow any more. Or, in the language of the headlines, we hit the debt ceiling. If that sounds like an awkward situation, it is. And it raises several very real economic and market risks that are being fully played out in the headlines. Many of you have been asking what this all means. So, let’s take a closer look. 

Debt Ceiling in Context

As you probably know, the U.S. government runs a deficit (i.e., it spends more than it brings in), so it continually borrows more to pay the outstanding bills. The problem is that Congress has limited the total amount the government can borrow (the debt ceiling). So, on a regular basis, Congress needs to raise that limit—to account for the deficit spending Congress has approved. Raising the debt limit has become a regular political football, which is why we are having this conversation again, as Congress has not raised the limit. As of today, we are now at it again. 

Once the debt limit kicks in, the Treasury cannot issue any more debt, but it still has to keep paying the bills. In the short term, that can be done. There are well-defined “extraordinary measures” that have been tested in previous debt limit confrontations. These include shifting money around different government accounts, robbing Peter to pay Paul, to fill the gap until more borrowing is allowed to catch up. Examples include suspending retirement contributions for government workers and repurposing other accounts normally used for things like stabilizing the currency. The idea is that this will buy time for Congress to authorize more borrowing, at which time everything will be trued up again. This is where we have been for the past several months. 

So far, so good. But if Congress doesn’t act (which it hasn’t) then at a certain point—now estimated to be June or July, but this is very uncertain—the Treasury will run out of money to pay the bills. Among those bills are the salaries for federal workers. So, at some point, the government will largely shut down. Some bills will get paid, but others will not. It is an open question how (and whether) the Treasury has the ability to prioritize payments. Simply, a large number of government obligations will go unpaid. 

Economic Risks Are High

Setting aside the politics of the situation, we as investors care about this issue for several reasons. First, cutting off government payments will hurt economic growth. Limits on, for example, social security payment would severely hurt both economic demand and confidence. While that would likely be the last thing cut, if possible, other cuts would also hurt growth and confidence. We saw exactly this in prior shutdowns, and the damage was real. 

The bigger problem, however, is if payments to holders of U.S. debt are not made and the Treasury market goes into default. U.S. government debt has always been the ultimate low-risk asset, where default was assumed to be impossible. So, adding a default risk would raise interest rates, potentially costing the country billions over time. The economic risk, both immediate and long term, is very high. And that’s what the headlines are playing off of. 

A Solvable Problem

Despite those headlines and the real risks, we don’t need to panic. This is a very solvable problem. In fact, we have been down this road before. While the ending could be bad, every previous time we ended up resolving the problem before the world blew up—and that is what will happen this time. Here are several ways the problem could be solved without systemic damage. 

Congress cuts a deal. This is the easiest and most likely course of action. At this point, it seems there is a small group of Congresspeople looking for an extended confrontation. Given that, a deal is very possible, and likely, as the pressure mounts. 

Legal fun and games. If Congress cannot or will not come to an agreement, there are other ways the government can resolve the problem before it erupts. Options range from the reasonably credible (using a line from the 14th Amendment of the Constitution to justify ignoring the limit entirely), to the reasonable but iffy (issuing lower face-value bonds with higher coupons), to the borderline crazy (issuing a trillion-dollar coin). The point here is not to dig into any of the options, but to show there are indeed options short of default. Those options will happen before we default. As we saw in the financial crisis, the government is willing to do a lot of things previously unimaginable before letting the world blow up, and I am quite certain that would be the case here as well. 

Working through the “default.” If Congress does not act, it is still not the end of the world. First, a “default” happened in 1971 for technical reasons. Investors looked through the default because it wasn’t for economic reasons, and the long-term consequences were minimal. Second, any default this time around would be political, not economic. When countries default because they can’t pay, that is a systemic problem: the lenders won’t be getting their money. In this case, though, we can pay and will. It will just take some time to get through the political process. If you think about it in personal terms, a late mortgage payment is very different from foreclosure. 

Investors are smart enough to make that distinction. We saw this most recently a couple of years ago, and it has been a regular theme for the past couple of decades. Markets have largely learned to look through the process. Could we see some volatility? Quite possibly. But we are not really seeing it yet, suggesting markets expect the same old movie ending again. No one—no one—is talking about repudiating or really defaulting on U.S. debt over time, and the markets are reflecting that. Real default won’t happen, even if temporary default does. 

So, What Does This Mean for Us?

The short answer is simply this: don’t panic. This has happened before and will no doubt happen again. The headlines are making the most of what could happen, and the worst case would indeed be bad. But we have a ways to go from here to there, during which there are enormous incentives to cut a deal. And even if a deal is not cut? There are other, non-default options. If we do get to default, the likely market volatility will drive a deal at that time. There are many ways to solve this problem and only one way to fail—which means it really isn’t an option. 

This is a big deal and worth watching, but it’s not worth worrying about yet. We will be keeping an eye on this, with regular updates. In the meantime, keep calm and carry on. 

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