May 19, 2023 FAS Market Update May 2023
The saying goes “in this world nothing is certain except death and taxes”, when in reality the saying should probably be something along the lines of “nothing in this world is certain except death, taxes and the U.S. overspending.” It is once again about that time every few years when panic ensues in DC and across the media over the fact that the country has hit its debt ceiling and the threat of default looms over the country. But what does that actually mean and what exactly is the debt ceiling we hear discussed so much?
The way spending is structured in the U.S. is relatively contradictory compared to other developed nations. Congress, while having the power to direct spending and taxation through the legislative process, also holds the Constitutional power to borrow on the full faith and credit of the government.
Congress sets a budget every year that tells government bureaucracies how much they can spend and knows exactly what that total spending amount is. However, at the same time Congress limits the amount of debt that can be issued and the amount of tax they can collect because those are both separate issues to be voted on. This process is essentially akin to the head of a household maxing out the family credit card then subsequently calling their credit card company requesting to lower their borrowing limit.
While most may agree that having a debt limit is a necessity to provide a check on excessive government spending, the truth is that it has hardly acted as such over the years and has more or less become a political weapon brandished by both parties against the administration at that time. As the accompanying chart shows, spending has been parabolic and the debt ceiling has been raised or suspended 78 times since 1960.
A default by the U.S., meaning the government would be unable to meet its financial obligations, would have dire consequences. It would affect interest rates, the creditworthiness of the U.S., and most likely send the economy into a recession. But again, this is nothing new and there are several legal work arounds that can be taken by the Treasury called extraordinary measures.
Extraordinary measures involve drawing down the Treasury General Account, or TGA (essentially the government’s bank account with the Fed), as well as suspending investments into government retiree funds and pension funds to free up additional funding. The two of these together give the government a few months of runway until we reach the “drop-dead” or “X date” when funds are exhausted, which Treasury Secretary Janet Yellen recently announced would be June 1.
If and when that date were to come, as it nearly did in 2011, there are additional measures the administration could take. The most likely of those is prioritization of payments, which is for all intents and purposes a default – think paying your mortgage instead of your credit card bill. The bottom line is that you don’t have enough cash to meet your obligations even though your house isn’t being foreclosed on.
In the end, however, can the U.S. truly and legally default on its debt? According to Section 4 of the 14th amendment, “The validity of the public debt of the United States… shall not be questioned,” meaning the Treasury failing to pay its obligations would be considered unconstitutional, albeit there is no precedence nor prior ruling by the Supreme Court.
Regardless of whether it came down to determining the constitutionality of a default, the damage will have already been done to our nation’s creditworthiness, the exchange value of the U.S. dollar, money market funds and the functionality of the overnight repo markets.
The most likely scenario is our politicians will continue to play chicken with one another in attempts to get concessions from the other side of the aisle and point fingers when a deal is not agreed upon, until finally coming to an agreement in the 11th hour so as not to cause irreparable harm to our financial system. And if that doesn’t work, we’ll always have the trillion-dollar platinum coin option – but that’s a fallacy for another update.