Debt Ceiling Letter: May 2023
What happens if the US government defaults?
The debt ceiling fight
Come June 1st, if nothing is agreed upon, the US will no longer be able to pay its bills. While Congress appropriates money to be spent, the Treasury can only spend what it has “in the bank” and that pot is about to run out. The exact date when there will be no cash left is murky because money in the form of tax revenue is always coming in, but Treasury Secretary Janet Yellen has estimated the US has about two weeks left of bill paying power.
The debt ceiling is a construct of a 1917 law that limits the amount of borrowing the US government can take on. So, when more spending is approved than the US takes in – the normal for the past decades – Congress must agree to raise the ceiling. Such negotiations are a routine ritual and, in times of divided government, have often led to acrimony, ultimatums, and a game of chicken.
In today’s instance the sides seem firmly entrenched. The Republican led Congress has passed a bill that would require extensive rollbacks of recent spending by the Biden administration, while the administration has remained steadfast that the debt ceiling should be increased with no strings attached since Congress had already approved the spending. In the meantime, the debt ceiling has risen exponentially over the past several decades (see graph below).
Sources: White House Office of Management and Budget (limit); Treasury Department (debt, suspensions)
Potential resolutions if an agreement is not reached
In 2011 a similar standoff led to a down grading of US credit by Standard and Poor’s, in addition to an agreement to cap spending that handcuffed Congress, and the economy, for years.
The current administration might have mechanisms that would circumvent Congress, but they are untested in the courts and certainly not infallible. Specifically, a reading of the 14th Amendment implies that it is unconstitutional to create doubt about the intention of the US to pay its bills. Invoking this would involve a court fight. It would likely be expedited, but it would still be highly disruptive.
Operationally, a default would require that the Treasury prioritize which recipients will be paid and who will have to forego payment. Common wisdom assumes that debt holders, or bond owners, will be paid first to create as minimal disruption to the credit markets as possible. Social security recipients are also considered a priority, given the strength of the senior voting block.
The expected outcome
Nevertheless, the US has never encountered such a default. We do not know if the parties will reach an agreement or how the mechanisms of payment will work if such a default leaves the government with no cash. Nor can we predict the potential impact on interest rates or the economy although we can make a couple of guesses. Most likely, interest rates would rise as investors flee certain US bonds, the value of the dollar would fall, making imports more expensive, and the economy would suffer from increased uncertainty. However, it is also possible, as we saw during the crisis of 2011, that interests might not move much (see graph below) or even decline as investors still view the US government debt as the least bad option for an even more uncertain future.
Source: Organization for Economic Co-operation and Development
In the end, however, we believe that the parties will ultimately increase the debt ceiling, and bills will be
paid, even if it must be in arrears. Furthermore, consumers will resume spending, travelers will travel, and
the economy will endure the blip to return to growth.
After any challenging economic environment, markets adjust to the news and incorporate it into prices,
then resume rewarding long‐term investors who were willing to put capital to work patiently (see graph
below). Our advice is to focus on your goals, be patient, and harvest the potential long‐term rewards.
Source: Dimensional. Growth of wealth shows the growth of a hypothetical investment of $100 in the securities in the Fama/French U.S. Total Market Research Index from July 1926 through December 2022. Gross Domestic Product (GDP) based on quarterly data from the US Bureau of Economic Analysis; quarterly data not available prior to 1947. Percentage change in GDP based on business cycle peak to trough quarter as reported by the National Bureau of Economic Research (NBER). Industrial Production, Inflation, and Unemployment based on monthly data from Federal Reserve Bank of St. Louis (FRED); Unemployment data not reported prior to 1929.
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