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The US debt ceiling
May 2023. Crises in financial markets are mostly unpredictable and the result of a misunderstanding of risks and genuine mistakes. We could however be headed for a major crisis which is completely avoidable, save for the deep political polarisation in the US and some of the arcane laws in place regarding how much debt the country has outstanding.
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Recent updates30/05 - The US appears to have reached a debt ceiling deal The US debt ceiling drama seems to be moving behind us, as a moderate President and a less-than-expected-militant House Speaker reached an accord that will only have a moderate impact on growth. It remains to be passed by the individual caucuses in the Senate and the House, but the probability of a signed deal before the 5th June x-date seems very possible – at the time of writing (large caveat, this is politics). Washington hasn’t seen real bipartisanship since before Dick Cheney’s Vice Presidency. Points for the deal should go squarely to a President who knows the system like probably no one else. More importantly, both party leaders have said that they would be happy to sign a deal even if that meant ignoring downvotes from their respective fringes. It may be premature to assume, but a return to the political centre after more than a decade could be better news than the debt ceiling deal itself. In fact, a broad look at elected legislatures across the developed world, from the UK to France to Greece suggests that we may be close to a return to the more centrist policies that were prevalent before the 2008 Global Financial Crisis. The centre is where most things get done. Not all at once, but inch-by-inch (or centimetre-by-centimetre if you prefer). Big partisan laws, like Obamacare or the 2018 tax cuts, may move the needle quickly, but tend to generate so much backlash that their cost can be measured in generations. 22/5 - All Quite On the wester front. Perhaps too quiet Recent talks between President Biden and House Speaker McCarthy seem positive. However, we are ever mindful of George Orwell’s quote: “Political language is designed to make lies sound truthful […] and to give an appearance of solidity to pure wind”. On 1 June it is expected that the US will run out of funds to pay of its debt and, with little known about if and when the debt ceiling may be raised, we are still in the dark about what the future holds. Equally dangerous is that we haven’t seen the details of this deal-in-the-making. Nowhere is the devil more comfortable than in the details. It could very well be the case that there’s a real deal ready to be signed, but also that the ‘Grand Compromise’ will end up hurting growth over the long term, much like it did in 2011. Short-term fast money, which cares little about fundamentals, may have good reason to celebrate. Long-term investors, however, should wait until the debt ceiling deal is signed, the ink is dry and all details have been scrutinised before even considering uncorking the champagne bottles. 15/5 - A US debt default could happen. What then? In the next couple of months, the world’s biggest economy will either decide to increase its debt or default on its payments (internally and/or externally). It is, of course, easy to dismiss the upcoming battle as the usual political posturing which will inevitably end with some sort of compromise deal. And, despite the acrimonious build-up, it is still our base case scenario. However, the lesson from Covid-19 is that we should be very careful as to what we dismiss as “one of those things”. Tail (low probability) events exist. Is this instance close to becoming a tail event? We believe this time, the risks are more pronounced and that we could, at least, see a replay of the 2011 Debt Ceiling Crisis. |
What is the US debt ceiling?
Unlike other countries, where the level of government debt is just a by-product of laws passed and there are no formal limits in place, the US Congress has to authorise the issuance of debt beyond a certain level.
Despite its flaws, this system is more manageable than procedures prior to 1917, when Congress had to authorise each specific loan or bond issuance. Until the 1990s the debt ceiling was raised without issue as needed, with US debt increasing under every administration since Herbert Hoover. Since 1995 there have been numerous government shutdowns and debt ceiling crises, particularly when Republicans control the House and want to obtain concessions from a Democratic president.
What is so odd is that, by not agreeing to raise a debt ceiling, Congress is essentially refusing to cover the cost of legislation that has already been passed. This dynamic occurs when, given the chance, Democrats tend to pass social security packages, while Republicans pass tax cuts, both struggling to reverse the others’ policies, resulting in ever-rising debt.
In the last few years, there has been increasing polarisation and disharmony between the left and the right, and with Republicans having the mantle of the party of small government, they have been willing to try and use the debt ceiling to achieve their goals.
So how worried should we be about a US default?
Historical precedent suggests that eventually, both will come to an agreement, as happened in 2011 and 2013. Circumstances this time however give rise to serious doubts this will be the case. Republicans have a very small majority in the House, so have had to pass a bill that was acceptable to some of their more extreme members.
There is no way that a bill, that would reverse significant spending, passed by Democrats under the somewhat misleadingly named Inflation Reduction Act, will pass the Democrat-controlled Senate nor be signed into law by President Biden.
Meanwhile, even if House Speaker Kevin McCarthy wanted to raise the debt ceiling in a bipartisan manner (which he probably doesn’t), the new rules he agreed to in order to gain the Speakership mean he would likely immediately be removed from his position. With Treasury Secretary Janet Yellen announcing 1 June as the date the US could run out of cash, there is an increasing probability that the impasse in Washington will not be solved in time.
This all sounds like a binary outcome with a much greater probability of a US default than not, and if that were the case, equity and US Treasury markets would likely be much lower than they are at present.
As this is a man-made crisis, there could well be a man-made fudge, which could be why Democrats are unwilling to negotiate over the debt ceiling – they may (and it is a may) not need to.
There are three main ideas of how the debt ceiling can be circumvented:
- The Treasury has no limit on the value of coins it mints – as such it could print a $1tn (or any value needed) coin and swap it with the Federal Reserve for cash
- The Treasury issues debt with a very low face value but with very high interest payments
- There is a possibility that the 14th Amendment makes the debt ceiling unconstitutional anyway.
Perhaps surprisingly, the first option is the most likely to be used. The last option would very quickly get tied up in court and fall foul of a conservative Supreme Court, while the second option has foreseeable effects on the Treasury market.
While there is concern that the Fed may not accept the coin, and any action is likely to be heavily litigated, it would be hard to stop. current and previous Fed minutes suggest Chair Jay Powell has been open to the idea before. Given the financial stability mandate of the Fed, the unforeseen consequences would probably be more appealing than a US default.
George Lagarias, Chief Economist, James Rowlinson, Senior Investment Analyst
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