How can the debt ceiling bind?
As I discussed in an earlier Forbes article, the deficit is the annual difference between Federal government spending and tax revenue (if there is more revenue than spending, there is a surplus). The debt is the total of all deficits since the country began. The debt ceiling, which I decribed here, is the maximum debt that the Congress has authorized.
You might ask how the debt ceiling could ever be breached. Each year, Congress knows how much spending it has authorized, how much tax revenue it anticipates, and how much debt it has allowed the Treasury to issue (the debt ceiling). In effect, Congress knows the deficit in advance – it merely needs to adjust spending, taxes and borrowing to ensure that the debt ceiling isn’t reached or increase the debt ceiling to cover the growing debt.
Ah, but life is complicated. Here are some of the key complications:
- Countercyclical expenditures. Spending on some items (for example, unemployment insurance benefits) increases in bad economic times, when tax revenue tends to be lower. This increases the deficit (and thus the debt) by unpredictable amounts at unpredictable times.
- The political calendar. A key question is how much spending a given increase in the debt ceiling should cover. If the party currently in power increases the ceiling by a lot, that may allow the party currently out of power to increase spending when they return to power funded by a debt increase they don’t have to take responsibility for. That’s a political loss – the party now in power takes a hit for increasing borrowing, while the party currently out of power may get future credit for increasing spending. The political incentive is thus to increase the ceiling by the minimum amount possible to keep the borrowing flowing throughout the current term, but not beyond. In addition, there is a…
- Timing mismatch between legislation and realization of deficits. Legislation this year influences deficits in future years. One Congress can produce a future deficit which might require future Congresses to increase the debt ceiling or taxes, or alternatively to reduce spending.
- Timing mismatch between spending and receipts. Tax receipts are high in March and April of each year. Spending on many categories is smoother throughout the year.
What happens when the debt ceiling binds?
When the debt reaches the debt ceiling, the Treasury can’t borrow any more resources. It must fund spending out of receipts from taxes and fees. Since the government is running a deficit, planned spending is less than tax and fee receipts. Something’s gotta give!
The Treasury does what anyone does when funds are short. It pays slow. (Officially, the Treasury employs “extraordinary measures.”) The Treasury can pay three major recipients slow:
- The Thrift Savings Plan (TSP): The Federal employees retirement fund holds special government securities that mature daily. The Treasury stops replacing these securities and paying interest on them – leaving room under the debt ceiling to issue securities to the public. When the debt ceiling eventually rises, the Treasury replaces the securities in the TSP and pays interest to make the retirees whole. The TSP is large, by the way, nearly $750B in assets. Not all of that is in the special securities I mentioned, but there is still considerable scope for delay.
- The Exchange Stabilization Fund (ESF): This fund used for currency-related operations uses the same securities as the TSP. The procedure is the same.
- Civil Service Retirement and Disability Fund (CSRDF): The main pension fund (over $900B in assets) for Federal employees also holds Treasury securities. The Treasury doesn’t pay interest on these securities or roll over maturing securities until the debt ceiling rises.
Who else waits for payment?
These extraordinary measures opportunities are limited. Once they are exhausted, the Treasury must pay slow to recipients who will notice, including (but not limited to) Social Security beneficiaries, Medicare service providers, government contractors, and Treasury security holders.
No one knows (or at least no one will say) exactly how that might happen. The Treasury has said that its systems cannot prioritize payments to one recipient or group of recipients over another. We do know, however, that interest on Treasury bonds is paid from a different system than the one (s) used for other recipients.
Imagine the furor and economic damage caused by delaying Social Security benefit payments! Many retirees rely almost entirely on Social Security. Delayed benefit payments would mean missed rent payments, financial difficulty in buying food, etc. Delaying other payments would have similar effects. At minimum, an economic recession would be almost certain, with the depth of the recession directly related to how long Treasury must delay payments (until the debt ceiling is raised). The pressure on Congress to raise the debt ceiling would be enormous – every member has many retired constituents. Retirees have time to complain, vent, and vote!
How would slow paying affect the global economy?
On the other hand, if interest payments on Treasury bonds are missed, the impact would spread immediately to the global economy. Treasury bonds are conventionally considered to be the “risk-free” asset and missed interest payments would constitute a formal default.
People and entities would lose faith in the US government and see its credit as less reliable than before. One of the pillars of the global economy would shake a bit. Interest rates would probably rise, stock markets around the world might decline, and the credit rating on Treasury bonds could fall.
Very importantly, however, the Treasury being unable to make payments in this situation would represent only a technical default, not a true insolvency. No one seriously doubts that the US government has sufficient resources to pay its bills. The debt reaching the debt ceiling says only that Congress has been unable to decide how to fund our spending. It does not say that we cannot fund our spending.
Financial crises are almost always triggered when creditors are surprised to learn that a significant borrower does not have sufficient resources to pay its debts. In this case, creditors would be disappointed to learn that the US government cannot decide which account to write its checks on.
The most recent debt ceiling crisis was resolved on August 2, 2011, the day the Treasury declared its extraordinary measures would be exhausted. The chart above (suggested by my colleague, Frank Napolitano) displays the performance of three mutual funds throughout 2011:
(orange): tracks the Bloomberg US Aggregate Bond Index
- SPY (blue): tracks the Standard and Poor’s 500 stock index
(purple): tracks 1-3 year Treasury bonds
What happened? As August 2 (circled) approached, stocks declined sharply, and the decline continued even after the crisis was resolved. The bond market rose somewhat, and interest rates fell. This is the opposite of what we would expect if investors had doubted the ability of the US government to pay its bills. Short term Treasury bonds (purple) hardly responded at all.
I don’t mean to suggest that markets will react the same way if Congress goes right up to or even over the brink in this go-round. I do mean to suggest that what will happen could easily surprise us. The timing and direction of market movements are unpredictable. It is likely that as the date of technical default (the “X date”) approaches, market volatility may increase.
What can you do to prepare for the potential crisis?
Any crisis related to the debt ceiling is likely to be short-lived because while some members of Congress may benefit from using the ceiling as a cudgel, none will benefit and all will lose if the Treasury stops making payments.
However, even a one-day suspension of Treasury payments would have consequences for the economy. For example, well-known business economist Mark Zandi points out (I’m paraphrasing.): “Even an inadvertent small delay in Treasury bill payments in the spring of 1979 resulted in a 60 basis point jump in Treasury bill yields which didn’t subside for several months. Taxpayers ended up paying tens of billions of dollars extra.”
It’s impossible to predict everything that might happen. It would make sense to hold some extra cash, especially if you rely on Social Security benefits in your monthly cash flow. Money market funds might not be the best location for cash you might need quickly – the Treasury bills that money market funds hold could fluctuate in value if the Treasury decides not to prioritize interest and principal payments.
It is less clear how to change your investment posture to gain or at least not lose if the Treasury “can’t borrow enough”. Predicting how any crisis would unfold and the impact on one or another investment is effectively impossible. A well-diversified portfolio is the best investment posture to cope with unpredictable risks of this sort. If some sectors benefit, you will too. If others are damaged, your exposure to them and your losses will be limited. Sticking with your long-term investment strategy despite the short-term political drama is likely to be the best approach.
The foregoing content reflects Rick Miller’s opinions and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct.
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.
Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.
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