Stay below this line, or else… 

 You have heard that before, I am sure. Our parents drilled those types of challenges into our tender minds as toddlers. Everything has its limits, especially when it comes to money. “You can’t spend what you don’t have,” so goes the saying. That applies to you, me, companies, and even the government… well not exactly. Of course, we can all borrow money, providing we have the ability to meet the terms of loan… more limitations. We should add on the above saying, “but you can’t borrow what you can’t pay off.” More limits. 

What about the Government? I can assure you that there was a day long, long… long ago where the US Government only would spend what it made in tax revenues. Are you chuckling? Sure, you are. It is true. To be clear, the US did have debts way back when the nation was born, but it wasn’t until the now-Broadway-phenom Alexander Hamilton became the first Treasurer of the upstart nation did the concept of debt management become fashionable. Hamilton, though he believed that debt was necessary to run a nation, tackled the nation’s debt, paying it down through tax and other revenues. As you might guess, the US has been wrestling with debt ever since. As it has so many times since those early days, the debt ceiling has become a lightning rod in Washington DC recently. This time, the issue has added urgency, as the current state of the US economy is weakened, and the capital markets are freshly off of weak 2021. Let’s have a closer look at the debt ceiling to understand what it is and what might be the implications if the ceiling is reached… the line is crossed, so to speak. 

A history of public debt 

As implied above, the US was already debt-spending when the nation was young. Wars cost money, governments cost money… you even have to pay the tax collector a wage. Back then, governments would borrow from other governments, monarchs, banks, and yes, even everyday rich folks. Turn the clock forward to 1835 when Andrew Jackson became President. He was determined to pay off the national debt, and indeed, he did pay it off. It must have been such a sense of relief… debt free. It was a great milestone for the US, and it lasted… for less than a year. Since then, the country has been in debt. When The Great War (WWI) began, the US Treasury, for the first time, issued US Government Bonds to anyone who wished to buy them. The War Revenue Act of 1917 made it possible for the Treasury to issue notes called War Bonds. As aforementioned, the US would borrow from other nations, but most of the country’s favorite lenders were embroiled in the conflict as well leaving the Treasury with no choice but to offer bonds to the public. We will get back to bonds in a bit, but for now, lets get back to the national debt… and illusiveness. In 1917, the Liberty Bond Act created the first statutory debt limit, also known as the debt ceiling. From that point on, any borrowing beyond the debt ceiling would require the approval of Congress. Well, as you might guess, the US has bumped up against that limit many times since it was enacted. Typically, the Treasury would request to have it raised by Congress, who would after some wrangling, either raise the limit or temporarily remove it altogether. Because debt spending is tied closely to the Federal budget, any political brinksmanship is typically between the President and the Congress. Indeed, there is much brinksmanship around the highly politicized event, especially when the President and Congress are from different parties. 

Back to bonds 

As discussed above, since 1917, the Treasury has been borrowing money through various programs. Most notable today are the Treasury Bills, Notes, and Bonds. With some $23 trillion outstanding bond debt, the Treasury is on the hook for making lots of coupon payments. Wouldn’t you know, the Treasury actually sells bonds to raise money to make payments on existing bonds. “Wait, what,” you exclaim! Isn’t that like a Ponzi scheme. If not, isn’t that exactly what our parents warned us not to do? Don’t use a new credit card to make payments on an existing maxed-out credit card. Are you getting stressed yet? Ok, it is really not that extreme, the Treasury uses all sorts of interest for “cash management” purposes. Please also remember that the Government has unlimited ability to raise taxes, though it would probably make a few people mad. Ok, let’s move on from this. 

What if? 

If the treasury debt ceiling is reached and Congress does not raise or eliminate it, then the Treasury would be at risk of default. That would likely cause the US’s already second-tier, AA-rating to be reduced, which would cause borrowing costs to go up and, thus, exacerbate the problem. Oh, it gets even trickier. Included in that debt is not just money owed to bondholders, but also money owed to Social Security. It can get big and messy. Before any of that happens, the Government would simply shut down, for want of cash to pay workers. It has happened 10 times in history. There were 4 minor shutdowns in the 1980s under Carter and Reagan, a small one under Bush (H.W.), 2 under Clinton, 1 complete shutdown under Obama (16 days), and 2 under Trump (1 of which was the largest in history, 35 days). 

So, as you can see lots of bad things can come from hitting the debt ceiling without being able to raise it. That is precisely why, though it may get tense on Capitol Hill sometimes, an accord is usually made and a default avoided. On that note, the US never defaulted though it did get a Standard & Poor’s credit downgrade when default came close under President Obama. 

It’s just business 

Based on those ugly things that await us if Congress cannot negotiate its way to raising the limit, it is clear that no one wants to go down in history for being hard-headed and causing a debt default by the largest economic power on the globe. So, yes, indeed the ceiling has been raised in the past. To be exact, the ceiling has been modified on 78 occasions since 1961. The breakdown is somewhat surprising with 49 changes occurring under Republican Presidents and 29 modifications under Democratic Administrations. 

Right now 

Treasury Secretary Yellen has asked Congress, “respectfully” to raise the US debt ceiling. Big spending from pandemic-era stimulus packages and the recent infrastructure package has put a strain on the Government’s budget. Remember from a page or so ago when I brought up the Treasury’s using short term bonds (bills and notes) to fund payments for longer maturity obligations? In case you haven’t noticed, short-term interest rates have gone up… rather quickly in the past year or so. In fact, they just went up another +25 basis points as I edited this newsletter. Higher market-based yields accentuate the already growing debt mountain. Yellen has put Congress on notice, but she has some, what she termed, “extraordinary measures” to ensure that defaults can be avoided for several months. No one is sure what those measures are, but none of us would like to find out, either. 

In conclusion 

The Treasury Secretary has warned us that the country is at its debt limit. Extraordinary measures will avoid any risk of default for several months, giving politicians time to grandstand and negotiate a settlement. As in the past, lawmakers are likely to find a solution as no one would like to see a default. What happens if the parties get deadlocked and they are unable to reach an agreement. Well, a government shutdown would likely be the first casualty. Ultimately, the Government could possibly default which would unquestionably cause credit-agency downgrades. The currency would lose significant value and bond yields would shoot up to compensate bond holders for the additional risk. The Government, being riskier borrowers, would have to pay more to borrow money going forward only making the debt problem worse. For investors, a default would mean losses on bond portfolios and likely losses in stocks, as the default would impact consumer confidence and economic growth. Maybe we should remember what our parents taught us as toddlers. Don’t cross the line… maybe spend a little less.