The Actual US Debt Ceiling Q&A You Need Now

The 15^th time was the charm for new House Speaker Kevin McCarthy, who struck a deal with Republican holdouts in exchange for just enough support to win the gavel. Details of that deal aren’t public, but they reportedly include giving the rank-and-file more say over spending plans and … the debt ceiling. With that, murmurs about a debt ceiling-driven default later in 2023 have begun simmering. So with that in mind, we thought a return to basics to explore what the debt ceiling is, does—and what it doesn’t do—may be in order.

Note, as ever, we won’t get into the partisan politics of this subject. We analyze it solely to show the debt ceiling’s likely market effects (or non-effects) and show you why we think that. The assumption behind this latest debt-ceiling fear goes a little like this: The debt ceiling, suspended for most of the last three years, is back in force now, with only a skosh of headroom left to increase borrowing. Now that we have a divided government—one with a wing that objected to McCarthy as too much of a “dealmaker”—the excessively politicized parties aren’t likely to agree on much of anything.

So, many assume failure to reach a deal is likelier than ever, and chatter is rising about half-joking “solutions” like the Treasury minting a trillion-dollar platinum coin, depositing it at the Fed and using it to reset borrowing headroom. Maybe it will be harder to strike a deal. But hold the phone. We have heard similar rhetoric every time the debt ceiling has come up since 2011’s now-infamous episode—the reality of which doesn’t justify the infamy, as we will show. Congress has struck a deal every time. They likely will again. Maybe at the last minute. Maybe earlier. Maybe even a bit after the country runs out of theoretical borrowing room. But it is much too early to explore any of that. Now is a time to separate the wheat from the chaff on the debt ceiling, exploring what it is, why people worry and why you really needn’t, in our view.

What is the debt ceiling?

The debt ceiling is the statutory limit on the amount of federal debt outstanding at any one time. Congress created this limit in 1917 as part of the response to World War I. Beforehand, Congress had to vote every time the government issued debt to finance spending. That wasn’t very efficient in a time of global war, considering those are expensive. The debt limit allowed Congress to set a number that the Treasury could borrow up to as needed, but not beyond. Congress would then pass legislation to raise it. You could argue that, considering the history, the debt ceiling was an efficiency gain.

Not so now. For one, it should be apparent the debt ceiling doesn’t limit debt. Since 1917, Congress has raised it well over 100 times. It has never failed to do so when needed. But many Americans dislike government debt, so both parties—yes, both—have at times used it as leverage to extract desired concessions from the other party, a move politicians can cast as being “tough on debt.” It really isn’t any such thing, but politics is about appearance more than reality. Today, it is fashionable to tie this to spending constraints, even though Congress enacts spending under separate legislation—the debt just facilitates it.

When might we hit the ceiling?

Well, we are very near it now. But the Treasury often invokes “extraordinary measures” like curtailing issuance of a special series of intragovernment bonds used effectively as accounting measures to stay under the ceiling for a spell. Treasury Secretary Janet Yellen said this morning that those can likely last through June. But that isn’t clear. There is uncertainty around the specific timing based both on economic forecasts and just how volatile economic output has been since the pandemic. The Treasury may wind up with more or less tax revenue than the Congressional Budget Office forecasts, which would swing the date around.

Why do people worry over it?

When one party tries using the debt ceiling as leverage, a common rebuttal from the other is that it risks US “default,” which sounds frightening. Now, the exact context of that term in these debates is vital. Default, technically, means only one thing: Failure to pay interest or principal on US Treasurys. But in these debates, a common tactic among pols is to change the definition, make it wigglier and claim default means, “failure to pay on any obligation.” That would rope in a lot of other spending, including things like payments to contractors, vendors and more. But you already know that isn’t default. How? We have had government shutdowns—like late 2018 to early 2019’s long one. During such periods, many workers are furloughed and not paid. Many non-essential government departments close and vendors aren’t paid. Yet no one calls those a default. Stocks historically haven’t batted an eye at shutdowns—they rallied throughout 2018/2019’s, which came after a sharp market correction unrelated to government operations.

OK. So default is failing to pay on Treasury bonds. What about that?

A true default would be quite bad. But it is exceedingly unlikely America would default on its debt even if it ran out of borrowing room. Actually, there is strong evidence it would be unconstitutional to do so.

To start with, as noted earlier, the debt ceiling is a limit that applies to increased borrowing. If a bond comes due, the government can issue debt while at the ceiling to replace it. That takes the issue of defaulting on principal off the table. Interest remains, but the government’s tax receipts give it ample cash to pay that without new debt. In fiscal 2022, which ended last September, federal interest payments were 9.7% of total tax revenue.^[i] Now, tax receipts and interest payments are lumpy, so let us explore this at a more granular level. Exhibit 1 shows the percentage of monthly tax take interest payments amounted to throughout fiscal 2022.

Exhibit 1: Fiscal 2022 Interest Payments’ Share of Tax Revenue by Month

Source: United States Treasury, as of 1/12/2023.

As you can see, in no month did interest top 29% of tax revenue. This means that even in the worst possible month last year, the government would easily cover interest due and avoid default—with some funds to spare.

Would they do it? Well, the 14^th Amendment’s Public Debt Clause, as interpreted by the US Supreme Court in 1935, says they must. It states: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” Subsequent governments have stated this means interest must be prioritized above all other payments—muting default risk.

OK. But don’t we run a deficit? What about the other spending?

It is true that in the scenario where the debt ceiling isn’t lifted and the government can’t increase borrowing, some spending cuts would be required. How exactly those look beyond debt payments is unclear, and we aren’t arguing this is a great way to set fiscal policy. Far from it. But the government’s revenues would cover a wide array of things beyond debt. And then it would be about choices. In some ways, it could resemble the aforementioned government shutdown.

Regardless, doesn’t 2011—when the US’s credit rating was downgraded and stocks fell—show the debt ceiling is bad?

Well, correlation isn’t causation. Yes, people were frightened by default talk and S&P downgrading America’s credit rating amid a debt ceiling fight in 2011. But there is missing nuance. For one, Congress raised the debt ceiling. Two, S&P’s downgrade hinged on a multi-trillion dollar math error, and interest rates fell afterwards. And three, it all came months into the eurozone’s debt crisis, when a regional recession loomed. That debt crisis drove corrections surrounding Greece in 2010 and fear of the euro’s sustainability in 2011 and 2012. That is some pretty vital context most common retrospectives on 2011’s debt ceiling fight and the stock correction then miss.

Well, let’s hope it doesn’t come to that.

Agreed! And it is highly likely not to. We have had divisive politics in America for a very long time, and yet, on the debt ceiling, politicians have always found a way to argue vociferously, promise no compromise, warn of fire and brimstone, then strike a deal.