During the last two months, the American political arena has been characterised by the recurrence of the debt ceiling as one of the main political questions. The topic may sound familiar to those readers interested in political and economic questions since it has been one of the most frequent concerns of the different Administrations. However, despite its recurrence, the possible economic and financial disruptions that a binding debt ceiling can create make it a key political event for the United States and the rest of the world.
In a general way, the debt ceiling can be defined as the total amount of money that the US Government is allowed to borrow to meet its existing legal obligations[1]. The main aim behind its creation in 1917 was to introduce a fiscal discipline mechanism as a way to limit the military spending linked to the first World War. Up until now, the debt ceiling, if reached, has never been binding due to the fact that it has always been raised, temporary extended or revised. Despite this and, apart from the political tensions between the Democrats and Republicans, the debt ceiling has had some short-term negative economic consequences, as showed mainly by the episodes of 2011 and 2013.
In the year 2021, the $28.4tn debt ceiling, suspended since 2019, was reached on the 5th of August. However, despite having reached the maximum cap, the accounting techniques used by the Treasury were able to reduce the amount of outstanding debt, allowing the US Government to continue satisfying its obligations. In light of past data on monthly revenues and spending, Yanet Yellen anticipated that the binding debt ceiling, taking into account the accounting techniques, would have been reached on October 18th. As in previous occasions, an extension of the debt ceiling, lasting until the 3rd of December, was approved. But, although the extension has provided some breathing space to the Biden’s Administration, the problem, instead of being solved, has just been postponed.
Trying to anticipate the possible effects of a binding debt ceiling is a complex exercise due to the fact that we have never had a US default. Despite this, the previous debt ceiling experiences of 2011 and 2013 and the stress that emerged in the Treasury market during March 2020 give us some hints about the possible effects of a binding debt cap.
From an economic point of view, a binding debt ceiling would negatively affect the level of consumption and investment due to the effects of the Government lay-offs, the delay of payments and the hit on consumer and business confidence. In addition, the suspension of some Government activities would also affect negatively to consumption and investment through the reduction of mortgages and loans to small business, two activities that rely on public information disclosure. When adding the likely financial disruptions that the default event can create, the results for the economy can be catastrophic. According to estimates by Moddy’s Analytics, the economic shock would be comparable to the Great Financial Crisis[2].
From a financial side, a binding debt ceiling would also imply huge financial market’s disruptions worldwide. In order to grasp the financial repercussions of the debt cap, it is important to understand the paper that Treasuries have in the financial system. When it comes to financial assets, the US Government debt is probably one of the cornerstones of the modern financial markets. This importance is mainly explained by the safety associated to the Treasuries[3], provided by the liquidity and depth of their market and the implicit support of US taxpayers. This safety makes Treasuries to be considered the risk-free assets par excellence, thus being used as a benchmark for the pricing of other financial products internationally. Apart from this, their quasi-money properties make them to be the main assets utilised as collateral in repurchase agreements as well as other money market operations.
In regard to the consequences of a Treasuries default, money markets will be the firsts to be hit. A default of Treasuries, accompanied by an expected downgrade of its credit rating, would put some pressure on money markets as a consequence of the current regulations. This is because the institutional investors in the money markets, mainly the Money Market Funds, have restrictions to hold securities below a triple AAA rating. The inability of MMF to hold downgraded assets would reduce their provisions of funding through repo operations, creating a repo market squeeze. Following this, if MMFs do not swap out the defaulted Treasuries and redemptions take place, the MMFs can start (fire)selling the Treasuries in order to get the cash. This sudden dump of US Government bonds would lead to a higher depreciation of their price that can impair the balance sheets of other financial institutions holding those assets. If difficult to anticipate, the financial disruption that MMFs can create would be important since the size of the industry is currently around $4.5tn, according to recent estimates.
Looking at the behaviour of investors during the previous days of the binding dates in 2013 and 2021, it is possible to see a clear pattern. As the graph shows, investors tend to substitute the bills whose maturity is near the binding date, pushing up their yields. In the case of the debt ceiling in 2013, the yields of the Treasury bills increased around 35 bp., around three times more than the 10 bp. rise of 2021.
Beyond the funding squeeze and the contagion among financial institutions, a binding debt ceiling may also affect negatively to the status of Treasuries as a safe haven asset. This would automatically imply less appetite for US Government debt and higher financing costs for the public and private sector. According to some estimates, the safe haven asset status of the Treasuries allows the US to reduce its financing costs around 25 bp. in comparison with other advanced economies. According to Brookings, 25 bp. in the current economic environment will allow the US taxpayers to save around $60bn in interest payments during this year and around $700bn over the next decade.
The recurrence of the debt ceiling has made policymakers to think about possible solutions to overcome the economic disruptions linked to a binding debt cap. In 2011, the US Treasury elaborated a contingency plan whose main aim was to avoid the default of Treasuries. According to the information provided, if the debt limit is reached, the Treasury would have to adjust their spending to reduce the cash outflows. This would be achieved prioritizing the debt interest and Social Security payments over other spending categories. Concerning the rest of the payments, they would have to be delayed until the day in which they can be paid together. In addition, new debt would be rolled over without increasing the maximum stock of debt allowed. With this option, the Treasury can avoid the default of the US Government, allowing the Treasury’s market to perform its key financial functions.
When it comes to the Federal Reserve, the Treasury market dislocation that took place in 2020 showed that the monetary institution is prepared to act. The ways in which the Fed can support the Treasury market were already communicated in 2013 and can take place to through the purchase or swap out of defaulted Treasuries and the provision of liquidity against defaulted treasuries in repo operations. Even though the Fed willingness to act, the central bank may somehow be reluctant to do it because the debt ceiling is a political question that must be left to politicians. Additionally, the emergency actions undertaken by the Fed in regard to the debt cap can be used in a political way. On the one hand Democrats can blame the Fed for protecting the Republicans from the consequences of their actions, on the other hand Republicans can blame the Fed of supporting the “socialist” agenda of the Democrats.
Looking at the evolution of the prices of the Credit Default Swaps, it seems that the financial markets have understood the commitment of the US institutions to avoid a default of the US Government debt. During October 2021, the prices of the US Treasury CDS increased less than 10 bp. in contrast with the 30 bp. rise in 2013. It appears that the recurrence of this event, together with the contingency plans of the US authorities, have made market participants to be less concerned about reaching a binding date.
[1] The amount of debt that the Treasury rises is determined by the difference between its revenues and its payment obligations, mainly determined by the fiscal decisions of past US administrations.
[2] Adding some perspective, the immediate decline of GDP would be around 4% with an unemployment rate increasing up to a 9%.
[3] The low or inexistent level of credit risk associated to the Treasuries makes them to be considered safe haven assets that are able to hedge portfolios against periods of market turmoil.
