A Q&A Ahead of the Debt Ceiling’s Big Comeback on Sunday

Editors’ Note: Our political commentary is intentionally non-partisan. We favor no political party nor any politician and assess political developments for their potential market impact only.

Look up! Do you see it? Over there? Looming on Sunday? Yep, you guessed it, the debt ceiling is back! Set to return from a two-year sabbatical and bring a whole bunch of misplaced default, downgrade and general debt fears with it. If this is your first potential debt ceiling showdown with us, welcome! In our view, getting informed now can help you keep your head if the political rhetoric gets very hot. So please journey with us through a fact-packed, irreverent Q&A.

What is the debt ceiling?

It is the statutory limit on the amount of debt the US Treasury can have outstanding.

Why does it exist?

It started out as a sop to lawmakers who were worried about runaway debt when Uncle Sam issued bonds to fund the war effort during World War I. At first, Congress had to individually approve every new bond issue. When that got too cumbersome, they established the debt ceiling, allowing the Treasury to issue bonds as needed without getting a permission slip each time, up to a certain limit.

What happened when they hit it?

They raised it, because like all lines in the sand, its primary purpose is to be wiped and redrawn.

Sounds fairly civil. Why does it seem so nasty now?

Later in the 20^th century, politicians figured out that they could use the debt ceiling as a wedge issue in campaigning and fundraising, a way to paint your opponent as irresponsible. They also realized they could hold it hostage in order to pass more contentious issues—duct tape something mandatory to a nice-to-have, and you theoretically have a better chance of getting what you want.

Ah, so self-interested politicians strike again?

Yep.

Ok so what happens when debt hits the ceiling? I mean aside from the shouting? Operationally?

The eventual outcome, over 100 times now, is that Congress eventually raises it. Sometimes they raise it to a new arbitrary level. In recent years, they have preferred to suspend it temporarily until a fixed date. That is what they did last time around—they suspended it for two years until August 1, 2021.

Now, Congress doesn’t always address it right away. Over the past decade, they have dragged it out for weeks or months.

Wait, so the Treasury sometimes can’t borrow for months? What happens then?

Politicians and pundits will tell you the US risks “defaulting” on its “obligations.” That is politicized exaggeration. What actually happens is that the Treasury uses what they call “Extraordinary Measures” to keep meeting “obligations” without new borrowing.

That sounds like a bad movie and a good band name.

We agree. It also isn’t as exciting as it sounds. It just means they put IOUs into Social Security and other long-term funding commitments so that they can keep paying staff, vendors and debt interest.

Can that last indefinitely?

Nope. It usually buys about two months. This time, the Congressional Budget Office estimates extraordinary measures will run out around the beginning of October.

Oh yah, I saw that report—and all the press coverage said that is when the Treasury won’t be able to meet its obligations anymore, and I think that is when we default?

Nope.

But the Treasury Secretary said …

We know.

And politicians in both parties said …

We know.

And pundits and past presidents and Treasury officials …

We know.

Well then, why does the Treasury’s “not meeting obligations” not count as default?

Default is one thing and one thing only: failing to pay interest and principal on debt. If the Treasury can’t pay Dunder Mifflin for its monthly paper shipment, that isn’t default. Giving the caterers an IOU isn’t default. Greece didn’t nearly crash out of the euro a decade ago because its government didn’t pay the electricity bill—rather, on three occasions, it failed to service debt.

Exhausting extraordinary measures and the Treasury’s cash on hand (which happened in 2015) doesn’t prevent debt payments. Paying principal on maturing debt is covered, easily, because the Treasury can just refinance maturing debt—since that doesn’t increase total debt outstanding. As for interest payments, there is plenty of money in the kitty. Exhibit 1 shows monthly interest payments and tax revenues over the past 12 months. As you will see, the intake far exceeded payments each time.

Exhibit 1: Monthly Tax Revenues and Interest Expenses

Source: US Treasury, as of 7/27/2021

Ok, so the math is on your side. But could the Treasury miss a debt payment just to make a point?

Legally? No. Past Treasury Secretaries have intimated that this could happen, spinning tall tales about having to pay the bills as they receive them—so that if interest bills arrive once other accounts payable have exhausted revenues, they will be forced to default. That is, how do we say this delicately, false. Waaaay back in 1985, when we were all wearing Mom Jeans the first time around, the Government Accountability Office wrote the following: “The Secretary of the Treasury has the authority to determine the order in which obligations are to be paid should the Congress fail to raise the statutory debt ceiling and revenues are inadequate to cover all required payments. There is no statute or any other basis for concluding that the Treasury must pay outstanding obligations in the order they are presented for payment.”^[i] In 2014, after arguing the opposite in several high-profile debt-ceiling fights, the US Treasury admitted this was possible.^[ii]

Oh, and 50 years before that, the Supreme Court opined that the 14^th Amendment requires the Treasury to honor debt payments above all else.^[iii] We are not lawyers (thankfully), but this seems to us like a legal requirement to honor the debt above all else, which may require the Treasury to prioritize debt payments.

Back to the politicians. I see a lot of claims about needing a bipartisan deal to get this done. Fact or fiction? That doesn’t seem too likely…

Fiction. This happens every time, with both parties guilty. But if the House and Senate are controlled by the same party, the majority party can always pass a debt ceiling increase on straight party lines. They simply use budget reconciliation. Despite all the talk about needing to tie the debt ceiling to the spending bills, the 1974 budget reconciliation rules allow Congress to use reconciliation to raise the debt ceiling once per year. That can be in a standalone debt ceiling bill or in a broader tax or spending package. Dealer’s choice, basically.

So why are they saying …

Politics? Marketing? Riling up voters? The usual games?

What about stocks?

They know the drill. Again, we have seen this dreadful movie over 100 times before. Stocks know this won’t lead to default. They know it is just political gamesmanship. That is why no debt ceiling standoff has ever caused a bear market. Short-term volatility is always possible, for any or no reason, but overall, the debt ceiling is a classic false fear, in our view.

What about the bond market? Will interest rates spike?

We don’t predict short-term volatility in stocks or bonds, as doing so is impossible. But 10-year yields fell after a math error and debt ceiling bickering prompted Standard & Poor’s to downgrade the US’s credit rating on August 5, 2011, which we will have more to say about next week. But in the meantime, we think that is shining evidence that bond markets, too, know the score.