Question:  

Would you explain the U.S. government debt ceiling and why it matters?

Answer: 

The U.S. government has a borrowing limit that was maxed out earlier this year. The debt limit allows government to finance past spending as it comes due and is not about new spending. 

Because tax revenue doesn’t cover government expenditures, debt is necessary to pay current bills. The debt ceiling sets a maximum on the outstanding debt level the U.S. government can have. Once realized, this cannot be increased until Congress makes adjustments. Clear as mud, right? Keep reading! 

Failure to reach an agreement on the debt limit has consequences for financial markets with a risk that the U.S. government defaults on its debt. While it’s widely expected that lawmakers will strike a deal and raise the debt ceiling, they’ll likely politicize the discussion and wait until the last possible moment.

Policymakers can agree to raise, suspend, or eliminate the debt limit and continue paying our obligations for a limited time. Unless they agree on a course of action, the government could run out of cash to pay its bills this summer. The stakes are high, and it looks like our deeply divided government will bring us to another debt-ceiling showdown. Divided governments have typically been good for the markets; however, when negotiating fiscal matters, it can spell trouble. 

Why? 

The debt ceiling law was created during World War I to simplify the process of issuing debt to fund war operations. In 1939, Congress established an aggregate debt limit, which legislative action increased or suspended regularly since then. Between the 1960s and today, the debt ceiling has risen 78 times. The most notable showdown was in 2011 when political debate pushed the U.S. close to the brink of default. These battles typically occur when there is a Democrat in the White House and Republicans control Congress.

What's behind the current impasse?

It’s no surprise that the U.S. government is on an unsustainable fiscal path with debt and spending growing at an alarming pace. After last year’s spike in inflation, fiscal discipline is coming back in style. House Republicans made it clear they’ll push for budget reductions in exchange for raising the debt limit. Warnings from high-profile economists like Powell and Yellen about the consequences of not raising the debt limit are being ignored. The White House refuses to negotiate, wanting to pass a debt limit increase without addressing the current budgetary process.

This is a key point because raising the debt limit isn’t about new spending but allows government to finance past spending that has come due. Neither party appears ready or willing to negotiate. The closer we are to the date the U.S. government officially runs out of money, the closer we are to defaulting. If this were to happen, it would send shockwaves through financial markets.

Consequences 

The U.S. government has never defaulted on its debt; however, the market is getting increasingly concerned about this possibility. In 2011, the political battle pushed us the closest we’ve ever been to defaulting on our debt. With no agreement in place as the calendar drew close to that 2011 ‘x’ date, U.S. equities declined nearly 15% in just a matter of weeks. Uncertainty spilled into international markets which fell nearly 30% as the drama unfolded. The dysfunction in Washington led to a downgrade in the U.S.’ sovereign debt rating. Market volatility was a key factor that drove political parties to the table for an agreement.

Only time will tell if history is going to repeat itself, but the stakes are high going into this year’s debt negotiations. Rating agencies warn that default would be a catastrophic blow to the U.S. economy, increasing borrowing costs and negatively impacting financial markets. With U.S. Treasury debt considered the world’s benchmark safe asset, uncertainty about the ‘full faith and credit’ of the U.S. government could have significant spillover into the international markets.

Conclusion

We’ve seen this movie before; if history is any guide, lawmakers will eventually strike a deal and raise the debt ceiling. There really isn’t another option, unless there is political will to repeal the debt ceiling law that was established in 1917. Given the divisiveness of politicians, it looks like we’ll follow a similar path as in 2011, where a debt limit agreement was reached, but at the last possible moment. Since we are still months away from the “x” date, the impact on the financial markets has been limited. But, as we draw closer to the “x” date, market turbulence is likely to pick up. However, experience indicates it will likely be short-lived. Stay focused and plan accordingly.