Posted by Brad McMillan, CFA, CAIA, MAI
In January, the U.S. has borrowed as much as it legally can and will be prohibited from borrowing any more. Or, in the language of the headlines, we have hit the debt ceiling. The
new Congress has failed to pass a law allowing the Treasury to borrow the money to make payments that previous Congresses have required the Treasury to make. The Treasury
will therefore have to use cash on hand right now, as well as any inflows, to pay the outstanding bills for as long as it can—until the money runs out.
If that sounds like an awkward situation, it is. And it raises a number of very real economic and market risks that are being fully played out in the headlines. Many of you have been asking what this means. So, let’s take a closer look.
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 are now and where we will be for the next couple of months.
What If Congress Doesn’t Act?
At a certain point—estimated to be around June right now, 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.
Setting aside the politics of the situation, we as investors care about this 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.
Should We Panic?
In a word, no. We have seen this movie before. While the ending could be really bad, every previous time we ended up resolving the problem before the world blew up. There are a couple of ways the problem could be solved before June. Congress cuts a deal. This is the easiest and most likely course of action. At this point, it seems there is a fairly small group of Congresspeople really 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 blows up. 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.
What If We Do Default?
It’s not the end of the world. First, it 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. 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.
What Should Investors Do?
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 months 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.