With frustrating regularity, the two largest political parties have again been haggling over a debt ceiling increase. In the hyper-polarized environment we find ourselves in, politicians are again using this routine financial maneuver to extort concessions from the other party in exchange for agreeing to raise the debt limit. While it might seem like disaster is approaching, we’ve been here many times. Despite the last-minute political brinkmanship and resulting volatility in the financial markets, our government has proven time and again to eventually do what it needs to do to keep paying the bills and avoid defaulting on its debt.
A bit of history…
The debt ceiling was created by the Second Liberty Bond Act in 1917 during World War I to simplify the process and enhance borrowing flexibility. The initial limit was $11.5 billion. It was further extended in 1939 to cover all government debt and set at $45 billion. It’s been raised over 100 times since World War II and suspended seven times since 2013 and currently stands at $31.381 trillion as of December 2021.
There have been several showdowns over the debt ceiling over the years, with some leading to government shutdowns, such as in 1995, 2011 and 2013. The 2011 crisis led to the US losing its AAA credit rating, a rating it had held for more than 70 years. While the specter of a possible default roiled the financial markets, Congress and the President eventually reached an agreement and raised the debt ceiling.
Where are we today?
The current debt limit was breached on January 19, 2023, and the Treasury has been using “extraordinary measures” since then to continue paying its bills and is expected to run out of options in early June, known as the X Date.
As the X Date approaches, the President and Congress have begun negotiating on raising the debt ceiling and appear close to passing a deal that would suspend the debt ceiling until early 2025, after the next Presidential election. A deal benefits both parties given the nature of the financial obligations the debt would cover. This scenario would result in the least amount of economic disruption in the short term, but means we’ll again be facing political brinkmanship in 2 years’ time.
Republicans in the House passed the Limit, Save, Grow Act, which would either suspend the debt ceiling through 3/31/24 or raise it by $1.5 trillion, in exchange for $4.8 trillion in 10-year policy savings, which would include cuts to many non-defense programs like Medicaid, food stamps, repealing energy tax credits and eliminating the program that cancels student debt. This scenario would actually damage the economy, given the required spending cuts and could result in a recession in 2024 and unemployment reaching 6% at its peak, according to a report by Moody’s.
Other options under consideration to avoid defaulting on the US debt include issuing a Trillion dollar platinum coin, issuing premium bonds or invoking Section 4 of the 14th Amendment of the Constitution, which says the validity of the debt of the US shall not be questioned. However, these options are seen as more controversial and less likely to be pursued.
Where do we go from here?
While it is uncertain which scenario will unfold now or in the future, given the political polarization in our government, there is a good chance the debt ceiling won’t get lifted until the very last second. Another possible scenario is the two parties agree on a short-term debt limit increase, to allow more time for negotiations. There is also a small chance that a few extremists in the House could force our country to default on its debt. Such a scenario, while unlikely, would cause serious economic damage and a big sell-off in the financial markets. It could lead to higher interest rates, a weaker dollar, and a decline in the value of US assets. It could also lead to a stock market crash, as investors panic and sell off their holdings.
In such uncertain times, diversification of your investment portfolio offers the best protection. It’s also important to be prepared to take advantage of any downturn in the markets, as such downturns can provide buying opportunities for savvy investors. Finally, it’s important to keep in mind that the debt ceiling crisis is a political issue, and while it can have serious economic consequences, it is ultimately a temporary setback that will eventually be resolved.