Yellen’s announcement may have triggered a sense of déjà vu among investors, who have become accustomed to the biennial political brinksmanship that accompanies debates over the rising federal deficit.
Recurring congressional debates over the US debt ceiling are often accompanied by demands for policy concessions from one political party or the other. The rhetoric often focuses on the need for greater fiscal responsibility and specific budget enforcement procedures. Unfortunately, while members of Congress have enacted various statutes to constrain spending, they have failed to slow the rate of growth in the accumulated deficit.
The ramifications of not raising the debt ceiling have become a principal focus for investors, so it seems appropriate to revisit the topic once again through a series of frequently asked questions.
What is the debt ceiling (or debt limit)?
The debt ceiling is a legal constraint on the aggregate amount of federal debt that the US government can accrue. The limit applies to almost all federal debt, including debt held by the public and debt that the US government owes to itself, such as securities held in Social Security and Medicare trust funds.
Why does the debt ceiling continue to rise?
First, the US government runs annual operating deficits, which are financed through the sale of securities to investors. Second, federal trust funds have run surpluses in the past, which were invested in government securities, and must be repaid over time.
Does increasing the debt limit authorize new spending?
No, raising the debt limit simply enables the government to pay its current bills, and to spend what Congress has already authorized and appropriated.
What are “extraordinary measures”?
The Treasury Department can use a variety of accounting and cash management maneuvers to avoid defaulting on its debts once the ceiling is reached. In the past, these have included halting employer contributions to government pension funds and redeeming Treasury bonds held in a variety of federal employee retirement savings accounts (which must be reimbursed when the debt ceiling is raised). The Treasury can also shut the state and local government (SLG) securities window temporarily and reduce the number of securities held in the foreign exchange stabilization fund.
What is the X-date?
The first day on which the Treasury Department has exhausted its borrowing authority and can no longer honor its obligations in full and on time is referred to as the "X-date." In other words, this is the day on which the accounting maneuvers are no longer sufficient to meet daily expenditure obligations, necessitating a higher debt ceiling and additional deficit financing to avoid a default.
Have we reached an impasse regarding an adjustment to the debt ceiling? Not yet. Congressional Republicans believe that negotiations over the debt ceiling provide an opportunity to reduce the size of the federal government’s annual operating deficit. Democrats argue that votes to raise the debt ceiling should be routine because the debt only pays for expenditures already authorized and appropriated. We expect negotiations to increase in intensity as the X-date approaches and anticipate a resolution at the eleventh hour.
How would government expenditures be affected in a default?
To the extent a default lasts more than a day or two, federal expenditures and transfer payments would be curtailed dramatically. Social Security checks would stop temporarily, as would veterans’ benefits. Active-duty military personnel would not be paid, and military deployments postponed. Medicare reimbursement payments would be delayed, and supplemental nutrition programs would cease until the ceiling was raised.
What is the economic impact?
The macroeconomic impacts would be profound. US Treasury securities serve as the foundation upon which other fixed income securities are valued. Prices of most other fixed income instruments would become untethered to the price of US Treasuries. The resulting disruption would raise the cost of capital for borrowers abruptly, distort global short-term funding markets, and undermine consumer confidence. The US dollar’s enviable position as the global reserve currency also would be undermined, and domestic economic growth would be suppressed.
What should investors do?
We believe the probability of an actual default is quite low. The narrow GOP majority and the broad philosophical chasm separating Democrats and Republicans suggest that the current atmosphere is similar to the one that permeated Congress in 2011. Thus, it is fair to expect that political disputes may not be resolved expeditiously. The deadline will be tested, but cooler heads should prevail.
The media attention now devoted to the issue is, counterintuitively, a positive development, as it may force members of Congress to remain more attentive to the adverse ramifications associated with a failure to reach agreement. The extraordinary measures now being undertaken by the Treasury Department will allow Congress to debate policy proposals for another four months. The political rhetoric today is combative, but that is not a new development in Washington. The accumulated federal deficit must be addressed and the current debate, however vitriolic, may be a necessary precursor to more responsible federal budget, especially in light of the recent and ongoing increase in the cost of servicing the debt.
In the meantime, investors should not overreact to the current bout of intense media scrutiny. Congress still has a considerable amount of time to resolve policy differences, and most members of Congress understand the economic and market peril of not raising the ceiling while longer-term solutions to the escalating deficit are identified. We recommend that investors discount the risk of a default and remain invested in accordance with their longer-term financial goals.
For much more on the debt ceiling, see the full report - Debt ceiling déjà vu, 20 January, 2023.
This content is a product of the UBS Chief Investment Office.
Main contributors: Solita Marcelli, Thomas McLoughlin, Leslie Falconio