The Debt Ceiling Is the Risk Wall Street Doesn’t Want To Think About
The consequences of the government defaulting on its bills are so terrible that investors just assume a deal will happen.
(Bloomberg Businessweek) -- Conventional wisdom says the US will avoid a devastating federal payments default later this year. But conventional wisdom has proved spectacularly wrong months ahead of shocks that upended the world in recent years: the failure of Lehman Brothers, the 2016 US election, the global spread of Covid-19.
The source of this potential shock is a procedural quirk of the US government that’s intersected with soaring partisan hostility. The federal debt has hit a legal limit imposed by Congress, and Republicans in the House of Representatives say they want concessions from Democrats and the White House before raising it. Such standoffs aren’t new. But lawmakers have never failed to pass an increase or suspension of the debt ceiling before the Department of the Treasury ran out of cash to make good on US obligations.
“If something has not happened for a long period of time, most people simply forget about it,” says Tyler Cowen, a George Mason University economist. He trained under Thomas Schelling, a pioneer in game theory—the study of how people vie for advantage or decide to cooperate. “We simply start assuming: ‘Can’t happen; it won’t happen.’ It’s not even within the set of our consciousness,” says Cowen, who’s also a Bloomberg Opinion columnist.
Financial markets are showing little sign of concern, and economists are shrugging off the risk that lawmakers might fail to make a deal. Most assume that in this game, the consequences of not raising the ceiling are ultimately intolerable to both sides. But the so-called X date—the day when the government won’t be able to pay all its bills—is just months away. And the politics driving negotiations this time around are shaping up to be more perilous than in previous episodes.
For Americans already struggling with high interest rates, a US payments default would push up borrowing costs for everything from mortgages and credit card balances to auto loans. Beaten-down 401(k) portfolios are in danger of further damage. The 2011 partisan showdown over the debt ceiling ended with a compromise that averted default but still sent the S&P 500 down 17%. This year’s fight is shaping up to be at least as contentious. “The market is quite complacent,” says Tracy Chen, a portfolio manager at Brandywine Global Investment Management in Philadelphia. “Investors should be very cautious” because “this time around, with regard to the debt limit, it will be an extraordinary and most acrimonious event this year,” she says.
The debt ceiling restricts the government’s ability to borrow to meet spending commitments Congress has already made. The US actually hit the limit in January, but so far the Treasury has been able to use special accounting moves to keep paying.
A default on federal payments would pose the biggest shock to the US financial system since the Lehman Brothers bankruptcy triggered the worst economic slump since the Great Depression. And while traders and regulators learned some lessons from the 2011 debt ceiling fight—which ended just days from a default—nobody truly knows whether the procedures in place would be sufficient to avert another systemic financial meltdown.
The Treasury’s first decision, once it reaches the X date, would be whether to prioritize some obligations over others—though some experts warn that it’s not possible to cherry-pick payments. Former officials assume the Treasury would keep making payments on the $24 trillion of publicly held government securities. Defaulting on those would undermine the bonds whose yields serve as benchmarks for the cost of borrowing around the world. Treasuries also serve as collateral for trillions of dollars of short-term money-market loans. They’re so built into the basic plumbing of the global economy that the damage from missed payments can only be guessed at.
“We do tabletop exercises, but it’s never actually been tested,” says Robert Toomey, a managing director at the Securities Industry and Financial Markets Association, the top US association for broker-dealers, investment banks and asset managers. “What the impact would be in the market is very much an open question with regard to—in the trading environment—how these securities will trade, what it will mean for pricing, etc. The consequences? Unknown.” Toomey says this is not an experiment SIFMA wants to see play out in real life. “Our opening premise is that we believe that the full faith and credit of the US government should not be compromised,” he says. “We should raise the debt limit, period, end of story.”
Prioritizing Treasuries would be politically challenging because the government would be making good on payments to wealthy investors and the likes of China’s government, while delaying indefinitely payments to millions of federal employees, contractors, military personnel, Social Security beneficiaries and others. But it could also affect how investors perceive US creditworthiness, potentially undermining the value of Treasuries and raising issues similar to an outright default on government bonds.
What if a Treasury payment had to be delayed? Key participants in the market have assembled contingency procedures over the years, aiming to allow for the Treasury each evening to roll over the maturity date of a security by one day if it had insufficient funds to pay off that obligation. In other words, it would delay paying the principal. Still, it’s unknown whether all systems would be able to process a transaction on, say, Aug. 10 for a security that was supposed to have matured and been paid off on Aug. 9.
Federal Reserve Chair Jerome Powell issued a warning in February that “no one should assume that the Fed can protect the economy from the consequences of failing to act in a timely manner” on the debt limit. And at a Senate hearing on Tuesday, he said any failure by Congress to resolve the issue could have “extraordinarily adverse” consequences, doing “long-standing harm.” The “only way out” is for Congress to raise the debt ceiling, he said.
One key danger that Powell homed in on a decade ago, when he was a Fed board member during a debt ceiling showdown in Washington, was that investors would be spooked into shying away from buying all of the US government debt being offered at a Treasury auction. “The real risk is of a failed auction, is the loss of market access at any price,” Powell said at the time, according to a Fed transcript of policymakers’ discussions.
With an auction failure, the Treasury might not be able to raise enough cash to pay off maturing debt, causing a cascade of problems. As then-New York Fed President William Dudley explained during the 2011 showdown, that would “certainly ratchet up the probability of a default” and “have a huge impact on financial conditions in the capital markets.”
Whether that’s how the story ends this year is up to politicians in Washington. There’s still time to act: Goldman Sachs Group Inc. estimates the X date will come in early to mid-August. But the intricacies of legislative procedure and the narrow margins of partisan control in the House and Senate aren’t working in Washington’s favor.
As in past debt limit showdowns, Republicans are insisting on spending cuts in return for lifting the ceiling for a Democratic president. What’s intensifying the tensions this time is GOP House Speaker Kevin McCarthy’s tenuous hold over a group of Republicans who say they’re determined not to compromise. On the other side, President Joe Biden and congressional Democrats have an incentive to showcase Republicans as extreme and destabilizing in threatening not to raise the $31.4 trillion debt ceiling.
McCarthy’s tortured path to winning the speakership in January illustrates the volatile state of politics: He fell short 14 times before ultimately winning on the 15th vote. One of McCarthy’s concessions in the process was allowing a single lawmaker to force a snap vote to remove him as speaker. That will give leverage to a small group of hardliners that can force changes to legislation—such as the debt ceiling bill—by imperiling McCarthy’s speakership. Even without such a threat, McCarthy can afford only four Republican “noes” on any party-line vote.
For conservatives, the debt ceiling debate offers a key pre-2024 election chance to paint Democrats as wasteful, inflation-inducing government spenders. They may need something dramatic, given that only 3% of Americans named the federal debt or deficits as the nation’s most pressing problem in a February Gallup poll, compared with as many as 17% in 2011. “It is an opportunity to raise awareness,” says Representative Scott Perry, who chairs the conservative Freedom Caucus. “You have to be able to use the moment to effect the changes so you don’t keep bankrupting the country.”
There is palpable glee among some of Perry’s allies about the chance to slash the size of government. Representative Thomas Massie of Kentucky, an engineer and hardline conservative, was beaming with delight as he left the House floor recently—showing off a suit-pocket debt clock he made from copper roofing materials. “Already, 20 members of Congress have asked me to make them one,” he said.
At the White House, Biden is clinging closely to lessons from the 2011 debt standoff. Many Democrats see the ultimate deal as having undermined the nation’s rebound from the global financial crisis, which may make them less willing to negotiate around deficits this time. For Democrats, the idea that Republicans are willing to engage in a game of chicken over the nation’s creditworthiness reinforces their efforts to portray the GOP as erratic, extremist and aligned with former President Donald Trump. “They’re playing Russian roulette with the economy,” says John Anzalone, who conducts polls for Biden. “The American people are going to punish them for it.”
Legislative solutions, apart from a grand fiscal deal between Biden and Republicans that now seems unlikely, include the potential for a number of moderate Republicans to join with the House minority to push through a “clean” debt limit increase—one without any conditions. But it’s a complex process that requires so much time it may be impossible. (Read more about legislative scenarios here.) The Senate side also faces challenges, with 24 GOP members having warned Biden that “structural” fiscal changes are needed to raise the debt limit.
A down-to-the-wire political solution could still involve major strains. As Dudley put it in the Fed’s 2013 discussion, there’s “a risk of something going wrong even if you have more runway than you think.”
In the worst-case scenario of a Treasuries default, “the burden on the US economy would take years to go away,” says Jack Malvey, who’s been watching the bond market since the 1970s and is now a special counselor at the Center for Financial Stability. “It will set off a chain reaction. We’ve never been in a default situation before.” Any short-lived halt in payments by the Treasury—whether interest owed to bondholders, salaries for federal workers or benefits to Social Security recipients—“would elicit a swift and potentially devastating market reaction,” wrote David Wilcox, director of US economic research at Bloomberg Economics.
Even if Treasuries were fully protected, cutting off millions of federal employees and entitlement beneficiaries would almost certainly trigger an instant recession. Recent war-gaming by Barclays Plc analysts showed the Treasury would need to cut some $200 billion of spending in the month of August if its borrowing needs were the same as recorded in August 2021. If it took weeks for the government to resume spending and make up for those delayed payments, “there could be a sharp drop” in gross domestic product of as much as 15% at an annualized rate, the bank’s team, led by Ajay Rajadhyaksha, wrote in a note to clients.
It might take some sort of market turmoil to force Congress’s hand. That was the case in the financial crisis of 2008, when the House in late September rejected a $700 billion bailout plan, only to clear a slightly revised version days later after markets plunged. For now, there are limited signs of concern. Economists surveyed by Bloomberg are convinced that the risk of default is very low—under 10%—and that the politicians will ultimately secure some kind of fiscal deal that’s linked to an increase in the debt ceiling. (Read more here.) And although the price of certain financial contracts that insure against nonpayment of US debts has gone up, investor concern has been softened by the lack of a precise deadline for resolving the issue.
The risk is that such a sanguine outlook will work against a deal: If no one thinks the worst will happen, they may be more willing to hold out. Economist Cowen thinks things will be “fine” this time, as in the past. However, he cautions that going through another tense process escalates the dangers. “Look, if you run the experiment enough times, sooner or later it’s not fine,” he says. —
(Updates the 12th paragraph with latest comments from Federal Reserve Chair Powell.)
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