To Raise or Not to Raise: The Debt Ceiling Conversation Nobody Wants to Have

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While the current public discourse over the debt ceiling has been omnipresent and politically driven there is a particular conversation that many seek to avoid: “What could really happen should Congress decide not to raise the debt ceiling?” Before engaging in such a conversation, it is important to state the facts.

The debt ceiling is the legal limit on the gross level of federal debt that the government can accrue. The limit applies to virtually all federal debt, including the debt held by the public, and what the government owes to itself through various accounts, such as the Social Security trust funds. The first version of the debt ceiling was established in 1917 and set at $11.5 billion. It was enacted to simplify the existing process and enhance borrowing flexibility. Since 1995, the debt limit has been increased 12 times, and in six of those instances Treasury took one or more extraordinary actions to avoid exceeding it.

The current debt ceiling stands at $14.294 trillion and Treasury projects the ceiling will be reached no later than May 16, 2011, though there are signs that some accounting sleight of hand is already being employed to avoid this scenario. However, should the debt limit be reached, Treasury would no longer able to issue federal debt. This means federal spending would have to be decreased or federal revenues would have to be increased by a corresponding amount to cover the gap in what cannot be borrowed. And in the current fiscal and political environment, one thing lawmakers on both sides of the aisle agree on is that while default is not an option, raising the debt limit is far from an attractive solution, politically.

Congress is not alone in between this rock and a hard place. A simple check of the polls reveals that a majority of Americans say they don’t want to see the debt ceiling raised. But when asked if they want it raised under the condition that spending is cut, a majority is in favor. Both President Obama and House Budget Committee Chairman Paul Ryan (R-WI) have proposed plans to limit spending over the coming decades. This is the first of many battles that will play out among those competing visions, and will serve as a backdrop for debates about structural, long-term spending cuts. More than anything, this year’s vote is simply a lever for those who want to reduce government spending substantially, and there’s little doubt House Republicans will hold out until there is agreement on significant cuts. And with the next election already clearly in their sights, members on both sides of the aisle have begun hedging their bets on this debate to position themselves for 2012 and beyond.

Ironically, the debt ceiling was not crafted to enforce fiscal discipline, but to fulfill a constitutional requirement that it is the job of Congress to approve all federal debt issuance. But without the ability to borrow, Congress might have to eliminate discretionary spending, cut outlays for mandatory programs, increase revenue, or take some combination of those actions in the second half of FY2011 and in FY2012 in order to avoid increasing the debt limit. And while it is understood that long before Treasury defaulted on its obligations it would stop making other payments first, unless the debt ceiling increases, Treasury can only buy about two more months (July 8, 2011) using “creative/extraordinary” financial techniques. 

Now that we have covered the facts, let’s talk about what could happen on July 9th if the debt ceiling hasn’t been raised. And true to form in Washington, the answer to that question is a subjective one. But first, context: not raising the debt ceiling is similar to seeing charges on a credit card bill, calling the issuer, and telling them although every charge was authorized and you appreciated their approval, you have just decided not to pay the bill.

In this context, one can better understand why Standard & Poor’s issued a credit warning two weeks ago; PIMCO, the largest bond fund, is selling its Treasuries; gold and silver prices are at astronomic levels; and the rates investors are willing to pay on the financial instruments used to insure against default are rising.  And while we would still have revenues to cover about 60 percent of our spending and interest on our debt, what and who would be protected is as certain as the Washington Redskins’ path to the Super Bowl. 

Without an explicit guarantee (i.e. law) telling institutional investors that they will be paid, there are experts who believe the consequences of a US default could spark yet another global financial crisis. The US could lose its triple-A rating, which could cause a sell-off in Treasury notes by institutional and foreign investors. This sell-off could lead to higher interest rates, and banks’ balance sheets might be decimated by the decline in their bond portfolios. Thus, global banking and financial market liquidity could dry up. Lending between institutions and people or businesses could possibly cease altogether or become cost prohibitive. Some believe this financial dislocation could lead key emerging economies such as Brazil, Russia, India, China and South Africa to demand that the dollar – which has been the global reserve currency based on confidence in the ability and willingness of the US government to pay its debts – be substituted for a different currency.

Some have suggested that lack of confidence in the US government to pay its debts could also call into question every explicit and implicit US-backed guarantee and credit enhancement. Such concern might have the added effect of upending consumer lending markets and bringing virtually all federally supported public-private-partnerships to a halt. And while there will likely be a brief period where the dollar will strengthen because of the Federal Reserve’s immediate need to monetize portions of the debt, an overly strong dollar could hamper US exports as they would be priced at an uncompetitive level, which could adversely affect countless industries. Furthermore, these industries would be forced to reduce their workforce as export opportunities shrink and the federal government, their main customer, cuts spending.

As the financial crisis grows, it could place an unprecedented strain in the Treasury bond market. The US losing a triple-A credit rating might lead to a fundamental reshaping of the global investment landscape because global asset prices are currently benchmarked against US Treasuries. And in keeping with the glass-half-empty approach, the end result could engender a new era of hyperinflation, which might wreak havoc on the world economy. 

But despite what some might deem doomsday scenarios as outlined above, the reality is that Treasury has many tools at its disposal to fund the government without having to issue new debt, and it can continue creating financing wiggle room on an ongoing basis. Despite the threat of looming deadlines and the fact that Congress has yet to produce any concrete deal elements, it is highly likely an agreement will be reached by the July 4th recess. And while in life – and politics – it’s always wise to prepare for the worst, default is simply not a probable outcome, and our nation’s path towards opportunity and prosperity will be clearer soon enough.