Another Debt Ceiling Game, Just A Different Year

What You Should Know About the Debt Ceiling Debate
 

President Biden and House Speaker McCarthy met to discuss raising the statutory limit on U.S. government debt, generally called the debt ceiling. Although both leaders called the discussion "productive," no resolution was reached but their respective negotiating teams continued the discussions. As of yesterday, it seemed like the talks were improving. The level of details both teams are discussing suggest the negotiations are becoming more serious and the teams are getting close, but still not close enough to seal a deal for the president to sign. 

Most of the back and forth has been about excluding defense spending suggested by Republicans and, in return, Democrats would like to maintain and expand some of their current welfare programs, including a drug price control that was brought up in negotiations. Rating agency and the implied risk of default are certainly adding pressure of both sides to reach a deal before the deadline. 

Here are some answers to questions you may have about the issues behind the current impasse.

What is the debt ceiling? 
The debt ceiling is a statutory limit on cumulative U.S. government debt, which is the sum of annual deficits since 1835. It limits the amount that the government can borrow to meet financial obligations already authorized by Congress. It does not authorize future spending. However, in recent years, raising the debt ceiling has been used as leverage to negotiate on the federal budget. 

Why do we have a debt ceiling? 
A debt ceiling was first introduced in 1917 to make it easier for the federal government to borrow during World War I. Before that time, all borrowing had to be authorized by Congress in very specific terms, which made it difficult to respond to changing needs. The modern debt ceiling, which aggregates almost all federal debt under one limit, was established in 1939 and has generally been used as a flexible structure to encourage fiscal responsibility. Since 1960, the ceiling has been raised, modified, or suspended 78 times, mostly with little fanfare until a political battle in 2011.

How much is the debt ceiling? 
The current limit was set by Congress at about $31.4 trillion in December 2021. For perspective — the debt was less than $6 trillion in 2001, when it began to rise due to tax cuts and increased military and national security spending in response to 9/11. It has tripled since 2008, driven by reduced tax revenues and stimulus spending during the Great Financial Crisis and the COVID-19 pandemic.

What will happen if the ceiling is not increased? 
The U.S. government will not be able to pay all of its financial obligations. This has never happened, so it is difficult to predict exactly how it would play out but these are some of the possible results.

  • The U.S. government could default on its bond payments. U.S. Treasury securities are generally considered among the safest investments in the world because they are backed by the full faith and credit of the U.S. government. These securities are widely held by individual and institutional investors as well as local, state, and foreign governments. Even the possibility of defaulting on interest payments could disrupt global markets, and an extended default could have serious economic repercussions around the world. Any default, or even near-default, could result in downgrading the U.S. credit rating, as occurred in 2011. This would make borrowing more expensive, adding to the ongoing problem.
  • Government payments could be delayed. Social Security and Veterans’ benefit payments could be delayed, causing hardship to those who depend on them for immediate needs. The same is true for wages of U.S. government workers, and late payments to government contractors could mean they may not be able to pay their employees. Late reimbursements to Medicare providers could strain smaller hospitals and medical practices. Any late payments would be made once the debt ceiling is raised, but the short-term consequences could be painful. 

What are the issues in the negotiations? 
According to public statements from negotiators, key issues include caps on future spending, use of unspent COVID-relief funds, work requirements for certain social programs, excluding defense spending, and expediting rules for energy projects. Both sides have agreed to spending caps in general terms, but they differ on how caps should be structured. The 2011 debt ceiling impasse resulted in spending caps, which had mixed results over the long term. Any caps would only affect discretionary spending, which accounts for just 28% of federal spending, almost half of which is for defense. The rest is mandatory spending, including Social Security and Medicare (which will account for nearly 35% of federal spending in 2023) and interest on the national debt.

Will there be a resolution? 
Both sides, Republicans and Democrats, have clearly stated they will not allow the U.S. government to default on its obligations, and, quite frankly, they cannot afford such a political failure. However, time is growing short. Any agreement must pass in both the House and the Senate, requiring at least some bipartisan support. Speaker McCarthy has said that an agreement must be reached early enough to give House lawmakers a required 72-hour period to review the legislation before the June 1 deadline. If an agreement is not reached by that time, a temporary measure could suspend or raise the ceiling for a limited period to provide more time for negotiations. 

If a resolution is reached, how would it look?
Although not confirmed, the terms of a possible deal look as follows: 

  • Debt ceiling is lifted until the end of 2024.
  • Imposed spending caps for at least two years.
  • Congress will need to pass an appropriation bill.
  • A tool to claw back funds if spending caps are not followed as the bill states.

Should investors worry? 
Although a default could have serious market repercussions, the most likely scenario is that the ceiling will be suspended or raised close to the deadline. We have watched that standoff game many times in recent years to believe otherwise will take place. 

While the U.S. debt is a serious issue, your investment strategy should be based on your long-term goals and risk tolerance, and it's generally wise to stay the course through periods of uncertainty. We recognize and expect that political conflicts may bring anxiety to investors but also believe that any related market volatility is likely to be temporary and dissipate once a deal is announced.

If you have any questions or concerns, please reach out to your First Bank Wealth Management Team.

 


Charles Claver
                            Charles Claver is a Senior Vice President, Director Investment Management & Trust and heads-up the Family Wealth Advisor team for First Bank Wealth Management. Possessing over 23 years of experience in the financial services field, his expertise includes investment management, trust and retirement planning, individual/commercial insurance, and private banking/lending. You may reach him at (310) 887-0100 or via email at [email protected].