The failure to raise the US debt ceiling in a timely manner will increase economic and financial uncertainty, raising the specter of a US debt default. After registering a deficit of $ 1.4 trillion in fiscal year 2022, the U.S. federal government has now reached the debt ceiling, which establishes the maximum amount of debt the federal government is allowed to issue. After reaching the ceiling on January 19, the Treasury began to take so-called “extraordinary measures”, which will enable it to keep debt below the ceiling until early June, depending on the evolution of Q1/ Q2 tax receipts. These extraordinary measures include the sale of existing investments and the suspension of reinvestments of various government-related pension funds, such as the Exchange Stabilization Fund, as well as the suspension of the agency’s issuance of State and Local Government Series Treasury securities. As far as the June estimate is concerned, the Treasury is likely to err on the side of caution so that a more likely date for the Treasury to run out of money will be the end of Q3. But as June approaches, market nervousness will increase, particularly if a political compromise on raising the ceiling continues to look out of reach, as this will increase the risk of a US debt default.
The politics of raising the debt ceiling will prove challenging, increasing the risk of potentially severe financial instability. A failure to raise the debt ceiling means that the government will lose the ability to raise funding to finance its ongoing fiscal deficits and ultimately to service its debt and other non-financial obligations, leading to a financial default and a significant decline in domestic spending and economic growth. In the coming months, the political debate in the U.S. will center around ways to raise the debt ceiling and prevent the federal government from running out of money to service federal debt. Politically, the standoff between Republicans in the House and the White House over the debt ceiling will be more difficult to resolve than in the past. House Republicans demand significant spending cuts in exchange for lifting the debt ceiling, but the White House has already made it clear it will not accept any conditions related to raising the debt ceiling. Some Republican senators back across-the-board spending cuts (incl. Cuts to the military budget). Aside from the ongoing political stalemate in Washington, the recent election of a much weakened speaker of the House of Representatives as well as continued concerns about the functioning of the treasury markets have increased risk further. The speaker of the House of Representatives, Kevin McCarthy, was forced to make significant concessions to the Freedom Caucus and right-wing conservatives in order to be elected. This will make raising the debt ceiling more difficult. As will the fact that the marginal, right-wing Republican House member has a greater electoral incentive to demand spending cuts and risk a default than incentives to cave in the face of the Biden administration’s refusal to negotiate. To make things worse, financially, the political process will unfold in the context of increasing interest rates and Fed quantitative tightening and the ensuing concerns about increased financial stability risks (sale of treasuries and agencies by the Fed) as well as heightened concerns about financial stability and the fragility of the US treasury market, which seized up twice in the past five years. The politics of raising the debt ceiling are challenging and a debt default is at least within the realm of possibility.
Politically, raising the debt ceiling will be messy. McCarthy was forced to offer three seats on the House Rules Committee to freedom-caucus or very conservative leaning members of his delegation. The committee is hugely important, as it decides what legislation advances to the House floor, what structure a debate takes and what amendments are admissible. If the three conservatives on the committee join up with Democrats, they can effectively block bills from reaching the floor. (There are nine Republicans and four Democrats on the Committee). And the three individuals that McCarthy appointed do have a history of holding up important legislation. Moreover, McCarthy had to agree to a change of rules that makes it easier to unseat the speaker, weakening his ability to keep Republicans in line and push through legislation. Moreover, the Republican majority in the House is very small, making its harder for the speaker to credibly commit to a compromise, should there be such a thing. There are congressional maneuvers that might allow centrists on both sides of the aisle to get around the House Rules Committee, such as the so-called “discharge petition”. But this is typically a lengthy and complicated process and may come too late in the midst of a fast-approaching financial meltdown. More speculatively, right-wing House Republicans will look at the 2011 standoff, which led the Obama White House to agree to spending cuts, and conclude that playing hardball may succeed, while the White House may view the 2011 compromise as a mistake. President BIden was the VP then. This would lead to a game of chicken, where the political logic leads to a major economic accident.
The Treasury may decide to take legally doubtful actions to avert a default once it exhausts extraordinary measures. If Congress fails to raise the debt ceiling and the Treasury runs out of extraordinary measures, it may resort to emergency measures to prevent a default. First, once it has run out of sufficient cash to meet all its payments, the Treasury could seek to prioritize principal and interest payments, while withholding other mandatory payments, such as social security, public sector salaries etc. Such a move would encounter serious legal and administrative challenges. It would also do little to calm markets unless it were seen by investors as buying enough time to settle the debt ceiling dispute. Second, the Treasury could try to mint a USD 1 trillion coin, deposit it with the Treasury, and ask the Treasury to use it to pay government obligations, or so it has been suggested. This would be legally doubtful to say the least. Some legal scholars have suggested that the 14th amendment, which states that “(t)he validity of the public debt of the United States authorized by law (....) shall not be questioned”, may provide a legal basis for the Treasury to simply ignore the debt ceiling altogether. All these executive maneuvers are legally highly doubtful and uncertain and they would be subject to court challenges. In practice, such measures would be seen by financial markets as smacking of desperation and might yet fail to stave off a financial crisis and concomitant economic downturn.
If there is a technical default, the Federal Reserve has various options to limit the fallout. First, to counter the risk of a broader destabilization of the financial system, the Fed could take supervisory and regulatory action allowing banks to count defaulted debt toward their capital requirements, be lenient toward banks that experience a temporary drop of their regularly capital ratios as well as direct banks to give leeway to distressed customers in order not to exacerbate the likely credit squeeze. Second, the Federal Reserve could simply buy defaulted debt (limiting the direct impact of a default on the financial soundness of financial institutions, in particular), lend against defaulted debt and/ or enter into repo transactions with banks and selected non-financial institutions (esp. money market funds) to limit the fallout in terms of financial losses and defaults. However, This may not help stave off a systemic meltdown and much will depend on whether markets believe that a default will be remedied quickly as well as how likely investors believe that such legally questionable intervention will survive legal challenges.
A US debt default risks pushing financial markets into a potentially major crisis and the economy into recession. Missing a payment on US government debt would lead to a sharp increase in risk aversion in US and global financial markets and a selloff of risk assets, such as equities, high-yield corporate debt and leveraged loans, and it might lead to a significant reduction in bank lending and credit in the economy. Similarly, a decision to stop non-financial payments would represent a major drag on economic demand, lead to increased risk aversion and also lead to sharply increased financial market volatility. Again, it is unclear what the exact market reaction would be in such a scenario. If markets believe that following a missed payment and Fed intervention to backstop the market Congress will come to its senses, a major destabilization may be avoided. If no end to the political standoff is in sight, markets may go haywire. Paradoxically, in both scenarios, it is quite possible that risk assets and equities sell off dramatically, but treasuries continue to benefit from strong demand, for lack of other global safe haven assets.
The failure to raise the debt ceiling would potentially trigger a deep economic recession and severe financial market instability. It would force a USD 1.5 tr worth of spending cuts this year and a total cumulative of USD 14 trillion over the next decade, according to the Congressional Budget Office. (The federal budget for next year is USD 1.7 trillion!) Leaving aside the financial implications of a debt default, such a massive reduction in spending would push the economy into a major recession. Some estimates have the output loss at minus 5% and job losses at 3 million. But these are at best mechanical guesstimates. In reality, the range of potential financial and economic outcomes is huge, but includes a major destabilization not just of US, but also of global financial markets. Longer-term, a US default, even if quickly remedied, would certainly boost the longer-term prospects of other international currencies, including the euro and the yuan.
