What could happen if the U.S. Congress doesn’t raise the debt ceiling and defaults on U.S. financial obligations.
In this episode you’ll learn:
- What is the federal debt ceiling and why does Congress always wait until the last minute to raise it.
- How long has the debt ceiling been in place.
- What would be the consequences of default by the U.S. government on its obligations.
- Why does the government continue to run a budget deficit instead of a surplus.
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Welcome to Money For the Rest of Us, a personal finance show on money, how it works, how to invest it and how to live without worrying about it. I’m your host, David Stein, and today is episode 169, titled “The Debt Ceiling – What You Need to Know.”
The Debt Ceiling
The U.S. Congress is currently on summer break, and when they get back, they’ll have about 12 working days to raise what is known as the federal debt ceiling – the maximum borrowing amount the U.S. Government is allowed to borrow, which is currently at 19.9 trillion dollars. It’s going to be pretty rough in terms of the negotiations, as it has been the last really 5, 7, 8 years. Particularly, the one time that I remember it being very, very severe in recent memory was in 2011, where the U.S. Government got very close to defaulting on its debt; the stock market sold off significantly… I remember writing a series of memos for our institutional clients at that time and learned a lot about the debt ceiling and these debt politics.
But the best analogy I can think of when it comes to the debt ceiling and how these things work is from when I was in high school. As a sophomore in high school, I was a beanpole; I was 6’1″ and weighed 130 pounds; maybe 131 if I was wearing clothes.
About that time, I got an issue of Sports Illustrated that profiled Herschel Walker, running back for the Georgia Bulldogs, who said that he didn’t lift weights. All he did to muscle up was push-ups and sit-ups, and I decided “I’m going to do that. I’m going to eat as much as I can, and I’m going to do hundreds of push-ups and sit-ups every day.” Well, maybe not hundreds… At least a hundred. I would do them in sets of 25, how he did, and I ate everything. I particularly remember eating a lot of peanut butter and jelly, apple sauce and sunflower seeds.
Within a year or so, I was up to roughly 170 pounds. I had raised my weight limit, my weight ceiling. I was able to raise that. How did I do that? Well, I ran a calorie surplus. I took in more calories than I expended as part of my exercise program.
Then as I got older — that target was 170-175 pounds, but I found that weight creeping up until I was in my mid-thirties, I was traveling a lot, I wasn’t eating particularly well, I wasn’t exercising, and I exceeded my weight ceiling of 190 pounds… And I just said “I’ve gotta do something about this.”
I researched, and I learned about how you lose weight… And this definitely is a simplification, because weight loss – your metabolism impacts it, as you know, and there’s just so much controversy. But at its core, nutritionists will say “To lose weight, you have to run a calorie deficit. You have to expend more calories in terms of energy consumption than you take in”, and that’s what I did. I was able to lose weight. So that was good, and now my weight goes ups and down, like everyone else.
But think about it, the federal government – its weight limit is the debt ceiling, and so the debt goes up because the government runs a budget deficit. If the government spends more than it takes in in taxes, then it’s required to go out and balance its accounting books and borrow the money.
Now, mechanically, the federal government doesn’t have to actually borrow the money in order to spend. Money is digits, they can just credit the checking accounts of whoever they want to pay. We learned about that in episode 157 most recently, “The most important economic question of our time.” But by the law of the land, they have to go out and borrow the money to balance the accounting books, and they can only borrow up to the debt limit, which is passed by Congress. That amount, as I mentioned, is 19.9 trillion dollars, and that’s just about where we are. If you round up, you’re at 19.9 trillion dollars.
Total debt then is 104% of gross domestic product. To put that into scale, that’s the most it has been as a percent of GDP since the end of World War II, where it was over 120%. What’s interesting is Congress knew when they passed the fiscal 2017 budget that they were gonna bump up against this debt ceiling. The total debt as of October 1st, 2016, was $19.5 trillion, and the expected budget deficit in this particular year (2016) was about $585 billion, and it was about the same in terms of what they expected deficit could be.
So, each year, the deficit gets added to the national debt, because the Treasury department has to go out and borrow those funds… There’s no surprises here; the numbers are known, so we want to see why we go through this – why doesn’t Congress just pass a budget along with perhaps raising the debt ceiling, but focus instead of all these arguments on the debt ceiling and taking us to just before default is imminent in order to come to an agreement… Which if a default occurs, we’ll talk about some of those potential issues that you can see if the federal government does default on its debt.
Now, while gross federal debt is $19.9 trillion, that includes debt that the government owes itself. A few episodes ago we talked about social security, the social security trust fund and how the surplus from social security is invested in special Treasury obligation bonds that the treasury issues to it. So if we back out, what the social security owns, what some of the other federal governments own – they owe debt to themselves.
Total public debt is $15.9 trillion. These are traditional U.S. Treasury bills and bonds, and it’s about 83.4% of gross domestic product (GDP), which is the measure of the economic output of the country.
Where It Began
So where does the debt ceiling come from? I found an interesting paper – it was “The debt limit: History and recent increases”, by D. Andrew Austen; he is of the Congressional Research Service. I’ll link to that in the show notes, and I’ll also send it to you. If you’re a member of my free Insider’s Guide, you have gotten that e-mail with those links, as well as the best writing that I do each week. You can sign up for that at moneyfortherestofus.com, or if you’re a U.S.-based listener, just text the word “insider” to the number 44222.
So this paper pointed out that the debt ceiling was first set in September 1917, and at that time Congress authorized the issuance of $7.5 billion in U.S. bonds, and later another $4 billion in certificates of indebtedness. This was part of the second Liberty bond act.
I had no idea that the debt ceiling was first put into place in 1917. So we’ve been going through this periodic raising of the debt ceiling for many, many years. Now, when it was first put in place, the limits were “Here’s the type of bond you could issue, and here’s how much.”
In 1930, Treasury Secretary Andrew Mellon, who was one of the longest-running Treasury secretaries – he served from March 1921 until February 1932 – he argued that “Orderly and economical management of the public debt requires that the Treasury Department should have complete freedom in determining the character of securities to be issued and should not be confronted with any arbitrary limitation.”
So in 1931 Congress granted this greater flexibility. And again, in 1935 Treasury Secretary Henry Morgenthau called for even more flexibility – just an overall aggregate debt limit, and it was set at that time, in 1935, at $45 billion.
Then came World War II, and I mentioned the great amount of federal borrowing, where federal debt got to be 120% of GDP. At that time, the federal government raised the debt limit to $300 billion and they later lowered it in its state at $275 billion until 1954. By March 1962, the debt limit again reached $300 billion, and since then Congress has enacted 78 separate measures that have basically raised the debt ceiling.
Every year, the national debt has increased. The exceptions were in 1969, and 1998 to 2001, when the government ran a surplus; then, obviously, a surplus didn’t require the need to borrow money. In fact, it allowed the total national debt to be paid down a little bit. So ,the U.S. federal government has again added Congressionally imposed debt ceiling, debt limit.
Steven Mnuchin, Secretary of Treasury, wrote Congress in March 2017: “I write to apprise you of certain upcoming events and actions related to the debt limit. Beginning on Thursday, March 16th, 2017, the outstanding debt of the United States will be at the statutory limit. At that time, the Treasury anticipates that it will need to start taking certain extraordinary measures in order to temporarily prevent the United States from defaulting on its obligations.”
The extraordinary measures are a number of programs. One – it was selling state and local government securities, which are special purpose Treasury securities that benefitted state and local governments; they were going to suspend those. They were going to stop investing the proceeds of the Civil Service Retirement and Disability Fund and the Postal Service Retiree Health Benefits Fund. So these federal workers are putting money into these federal retirement programs, which are then issuing special Treasury obligation bonds.
The other thing is, it was going to stop investing the Government Securities G Fund, which is another – actually, a great fund if you’re a federal employee. This is a government bond fund where you get basically the average interest rates on U.S. government bonds. But if interest rates go up, the value of the fund doesn’t go down. The way that the federal government does that is they issue these special obligation bonds.
So Secretary of Treasury Mnuchin and the Treasury Department are just going to stop doing some of those things, so they’re not issuing these special Treasury bonds and exceeding the debt limit. But at some point, Congress has to do that, and in the end, it has to do something. He ended the letter: “I respectfully urge Congress to protect the full faith and credit of the United States by acting to increase the statutory debt limit as soon as possible.”
He sent a follow-up letter in July 28th, 2017 that said: “It looks like the nation’s borrowing authority will reach that limit September 29th 2017.”
Why Are We Always Here?
So that’s where we are… Imminent default in a matter of working days once Congress returns, and it raises a question “Why do they wait until the last moment?”
Well, Andrew Austen of the Congressional Research Service writes:
“While the budget process provides Congress with one means of controlling federal spending, the debt limit may provide a different sort of leverage that is not redundant. Congress ordinarily delegates work to its committees. The committees on appropriations have special responsibilities regarding discretionary spending, and authorizing committees are generally responsible for mandatory program spending decisions, while committees on the budget are tasked with drafting an overall budgetary framework that specifies aggregate levels for federal spending and taxation.
While those committees often incorporate views of other committees and members, measures involving the debt limit often provide individual members not belonging to those committees with a separate instrument to influence federal fiscal policy.”
That’s the key… Other members that aren’t part of the budgetary process can use the debt ceiling negotiations as leverage to hopefully — in their case, they want to reduce the size of the federal budget, or they want some spending priority, or something, so they hold up the entire process hostage because they use it as a negotiating tactic.
What Happens in Default?
What is the impact or the consequences of a default by the U.S. government on its obligation, including Treasury bonds and bills? In 2011, the last time the U.S. government came very close to defaulting on its obligations, the U.S. Treasury Department put out a Frequently Asked Questions, and one of the questions was “What happens if the government defaults?” Here’s what they said:
“If Congress fails to increase the debt limit, the government would have to stop, limit or delay payments on a broad range of legal obligations, including social security and Medicare benefits, military salaries, interest on the national debt, tax refunds and many other commitments. Defaulting on those legal obligations would cause severe hardship for American families. Additionally, it would call into question the full faith and credit of the United States government, a pillar of the global financial system.
The ensuing financial crisis from a default would have catastrophic economic consequences, potentially including the loss of millions of American jobs, and it would lead to higher borrowing costs, reduced retirement savings and lower home values for families across the nation.”
Now, those are some pretty grave or dire warnings, but the reality is we don’t know what will happen. The U.S. government has never officially defaulted on its obligations. It did a little bit by accident in 1979 – Congress raised the debt limit at the very last minute again, but there was so much demand for redemption of treasuries that there was a word processing error and $120 million of obligations. Checks weren’t sent out on time, and so the government technically defaulted.
What happened? Interest rates went up. Short-term interest rates went up by 0.6%. The academic study by Terry Zivney and Richard Marcus show that they stayed up for months later. So that’s a given – if the country defaults, interest rates will more than likely go up, perhaps more than 0.6%, because that was kind of a technical word processing error, which they paid some interest to make it up.
So that’s a given – because investors around the world depend on U.S. government bonds, potentially interest rates go up, because suddenly Congress has shown that they are willing to let the government default… Because again, this is not a question of there not being money; this is all politics – holding the country’s credit rating hostage in order to negotiate whatever federal budget deal and debt ceiling limit.
Now, what I’m even more worried about is how treasuries are used. I’ve talked about this in the past; in episode 155 I mentioned the shadow banking system, which Morgan Ricks (a Vanderbilt University Law Professor) described as “A shadow bank is an entity that is not a chartered deposit bank and uses large quantities of short-term debt to fund a portfolio of financial assets.” In other words, shadow banks are financial entities that continually issue short-term debt instruments, and in that episode we talked about one of those, commercial paper.
Another one are repurchase agreements. What repurchase agreements are – somebody borrows money overnight, in exchange for collateral. That collateral is typically U.S. government bonds. Let’s say a prime broker is willing to lend to a hedge fund. So a hedge fund borrows money on leverage, so that they can make other trades. They’ll deliver Treasury bills or bonds as collateral, and then those prime brokers (somebody like a Goldman Sachs) will take that collateral and post it somewhere else, in order to perhaps borrow for their own. They might have depositors putting money in their bank, and they’ll post that collateral that they got from another hedge fund for that particular transaction. That’s called rehypothecation. It’s sort of this reusing of this collateral; it’s a collateral chain.
So if the government defaults on those Treasury bonds or its obligations, how that will impact these collateral chains – it could be you could have all these deals, this short-term lending, these repurchase agreements, people calling their collateral, it’s been rehypothecated, and it could be an absolute disaster. We don’t know.
Now, some have argued – particularly in Congress – that the government could prioritize which payments get made. “We’ll pay the Treasury interest rates, we’ll pay the Treasury bonds, we’ll pay our social security benefits. We won’t pay these individuals.” But the computer systems aren’t set up to do that. There is no priority. There essentially is a checking account at the Federal Reserve, and as the obligations come in, they’re paid.
Edward Kleinbard, a Law professor at the University of Southern California and a former Chief of Staff of the Congressional Joint Committee on Taxation wrote in the New York Times:
“There are profound doubts as to whether the Treasury could even implement prioritization beyond ring fencing interest payments, because its payment systems are designed to pay all claims as they are due, regardless of their origin. More important, prioritization is default by another name. The consequences are the same regardless of which I.O.Us the Treasury chooses to dishonor. All valid claims against the United States are backed by the credit of the United States.
The Constitution does not contemplate that some claims are more senior than others. The deliberate non-payment of billions of dollars of uncontested claims every month thus constitute default, even if the Treasury is paying some of its other debts. The resulting class action lawsuits will enrich generations of lawyers.”
About the National Debt
Now, I can understand that there’s some concern about the level of the national debt. Essentially, the publicly held national debt as a percent of the economy has doubled since 2009. It was around 40% of GDP, and now it’s over 80%. Why did that happen? Because we had a major recession. In 2009 the deficit was $1.5 trillion, $1.4 trillion in 2010, $1.4 trillion in 2011, $1.1 trillion in 2012. These huge deficits – that were a result of tax revenues absolutely declining, and expenditures for social safety nets such as unemployment skyrocketing.
In 2007 government tax receipts as a percent of GDP was 17.9%, and expenditures were 19.1%, so about a 2.4% deficit as a percent of GDP. By 2009, tax revenues had plummeted to only 14.6% of GPD, while expenditures increased to 24.4% of GDP. So 10.8% of GDP was essentially added to the federal debt. Again, in 2009 that was 10.8%, in 2010 it was 9.3%, in 2011 it was 8.9%, so huge increases in the deficits as a result of tax revenues declining and expenditures for social safety nets – automated stabilizers to help the economy get out of the recession.
Here’s the thing that we need to keep in mind – Congress, the federal government can control, to some extent, what is spent, but they don’t control the tax revenues. So the level of the deficit is determined by actions of private citizens, businesses, households. They decide what they want to save, how much they want to save. Whenever a household or business spends a dollar, that dollar is someone else’s income. So the only way households and businesses can save is to spend less than their income. But if every dollar spent is someone else’s income, and the only way to save is to spend less than your income, then it’s impossible for businesses and households collectively to save, unless there’s some other outside entity spending more than its income, running a deficit, and that entity is the U.S. government.
When businesses collectively try to increase their savings, which savings for businesses is their profits – so when they try to boost their profits by spending less, they do so by firing employees, by buying less from other businesses, which in turn affects those businesses’ income. Lower income for businesses and households due to higher unemployment, or because you’re just not selling enough because other businesses are cutting back, results in lower federal government tax revenue. Lower government tax revenue as a percent of GDP means that deficit gets bigger, and the national debt gets bigger.
Those deficits by the U.S. government is what allows households and businesses to save. The only other way it works is if a country runs a huge trade surplus, and so it brings in that income that allows for private sector savings by selling more overseas. But in a country like the U.S., that runs a huge trade deficit, the federal government has to offset that trade deficit even more, and the desire of the private sector to save, the federal government (by accounting definition, by simple math) essentially has to run a budget deficit, and that means the national debt keeps getting bigger and bigger… Because when the federal government runs a surplus, like it did 1999-2001 – what does that mean? It means it’s taking in more tax revenue than it’s spending. And if it’s taking in more tax revenue, that means that households and businesses have to come up with the money, it means they’re going to be ‘dissavers’, they’re not going to be able to save at all, because they have to come up collectively with money to send into the government, more than the government is spending.
That’s how the mathematics of — these are accounting identities. So Congress can worry about the national debt, but the national debt is a function of the budget deficit. Now, Congress can decide what they want to spend money on. They can adjust social security programs, they can decide that we don’t want to spend as much on defense, they can reduce other expenditures, but what they can’t do is control the amount of the deficit. That’s what the private sector decides, and because the private sector typically wants to save, that means the national debt is going to continue to grow on an absolute basis. It will exceed 20 trillion dollars.
What matters is what is the overall debt as a percent of the economy, and the deficits as a percent of the economy. In 2016 the federal budget deficit was 3.2% of GDP, pretty close to private sector savings as a percent of GDP. And that’s reasonable. We can have reasonable amounts – 3% or less. That’s normal, and that’s how the economy has worked for many, many decades without a crisis. Crises will occur if Congress chooses to default on the federal debt because they misunderstand how government finances actually work. That’s episode 169.
Everything I’ve shared with you in this episode has been for general education only. I’ve not considered your specific risk profile, I’ve not provided investment advice. This is simply general education on money, investing and economy. Have a great week!