The Debt Ceiling For Beginners

Markets are starting to get jittery about the debt ceiling, with no sign of a deal in sight. Will this time be different?

The Debt Ceiling For Beginners

It might be dominating the financial news right now, but we've been here before many times. Critics aren't seriously expecting anything to go wrong. It will (almost certainly) be a non-event. Right?

The debt ceiling is a lot like WWE. The wrestling between Republicans and Democrats over whether and how to increase the amount of money the government can borrow is a piece of political theater, partly scripted, and with a predictable outcome.

Predictable, because the alternative—not raising the ceiling and allowing the US to default on its debt—would put the country in (kind of) uncharted territory and very likely have serious implications for employment, the economy, markets, interest rates, inflation, and the US's perceived creditworthiness around the world. With the stakes so high, it's almost impossible to imagine that Congress would let the country spend its way over the brink.

But it's the "almost" that's the catch here, because there's just a chance a deal won't be reached. The wrestlers might go off script and actually start kicking off in earnest. We're used to eleventh-hour agreements—it's all part of the choreography—but there's always the chance that this time, things will, intentionally or otherwise, be different.

Debt Ceiling 101

As a quick bit of background, unlike most other countries, the US has a legal limit set by Congress on the amount of debt the US government can accumulate to fund all of its many operations, from subsidizing potato prices to invading middle eastern countries.

Once the ceiling has been hit, i.e. the government has sold all the bonds it can, it has a problem. Like a household that has maxed out its credit cards, it must either increase its income (tax revenues), reduce its spending (where's the fun in that?), or ask for its credit limit to be raised. Otherwise, it will default—those bond holders won't get the money they're owed—and that could cause a lot of problems.

For one thing, anyone who borrows from the US in the future is going to want a higher rate of return to compensate for the additional risk entailed in lending to a known deadbeat. That means more tax revenues go on interest payments, there's less money for other things like roads and welfare, and life gets generally worse for a lot of people. And that's just the start.

The US routinely spends more than it receives in revenues, so it needs to keep borrowing more and more to avoid a catastrophic default. (The alternatives, increasing taxes or decreasing spending, are both unpopular.) But that requires political agreement, and Republicans and Democrats have very different ideas about how to run the national economy responsibly.

What's Different This Time?

The debt ceiling has been raised dozens of times in the past, often without any great fanfare, especially when it hasn't required both sides of the political divide to work together. But where one or other side doesn't have the numbers in Congress to push things through on its own, it's often an opportunity for posturing and scoring political points. And America has probably never been more politically divided than it is now.

The list of sticking points is extensive, but in short, Democrats want to ensure the US pays its debts (which, yes, it has to borrow to do, because the spending Congress has already voted for can't be funded without raising the debt ceiling), and discuss the detail later, while Republicans want a raft of spending cuts before they agree to let the country borrow more. Neither side is willing to back down.

There's typically a lot of hand-wringing and excited political commentary around such debt ceiling negotiations, largely because that's the sort of thing that grabs the attention.

Meme of Beaker in the lab freaking out
Good news doesn't sell.

Markets are generally a pretty good indication of how serious things really are, because big money can only stay big by also being smart money. The markets haven't been too worried up until now—but that's starting to change. Yields on one-month Treasury bills have been creeping up, as the market starts to price in just the tiniest chance that maybe the US might not be paying those bondholders back, at least not on time. In particular, investors don't like bonds that mature around the crunch date, which could be within a week. And yesterday, stock markets dropped fairly sharply as a further round of talks ended without visible progress. Bitcoin, as another risk asset, was hit hard too.

One month T-bill rates over the last 5 days
Rising rates on 1-month T-bills reflect increasing concerns about US creditworthiness.

Back in 2011, we saw talks go down to the wire, prompting significant volatility on the stock markets, and a downgrade from its AAA status from rating agency Standard & Poor's. It's worth noting that the debt at that point was $14.3 trillion. Today, it's $31.4 trillion, having more than doubled in just 12 years. Both parties have done their fair share to max out the nation's credit card. Of the total debt today, writes NPR, "16% was added during the eight years George W. Bush was in office, 30% was added during the eight years Barack Obama was in office, 25% was added during the four years Donald Trump was in office – and 12% was added since President Biden took office."

BBC chart of US government debt.

Treasury Secretary Janet Yellen has repeatedly warned that the government will run out of money in early June, possibly as early as June 1 (it's hard to be precise because daily revenues and expenditure can be unpredictable). Republicans have openly questioned that "X-date", and if the government can limp on to mid-June then they'll get a few more buckets of tax payments to tide them over a while longer.

But that's a heck of a gamble to take, and the markets are just starting to shift uncomfortably at the prospect of the unthinkable happening.

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