International | Apr 21 2023
With the US set to run out of money in the next few months, and US politics at bipartisan extremes, another debt ceiling battle is underway which could have recession implications.
-US government forecast to run out of money possibly by July
-The debt ceiling must thus be raised or suspended
-Forced fiscal austerity would increase severity of recession
-History shows a resolution is always reached at the eleventh hour
By Greg Peel
The US debt ceiling was introduced during the First World War to allow Congress to determine a limit to what the White House administration could spend on fiscal policies. While the ceiling would naturally need to be raised over time in nominal terms to account for inflation, the fact it has been raised, extended, or revised 78 times since 1960 – 49 times under Republican presidents and 29 times under Democrats – makes one wonder what the point of the thing is.
Most countries don’t have debt ceilings.
But unless one party controls both houses of Congress, each time the US goes through the same charade, fighting back and forward for months until an eleventh hour resolution is inevitably met. As Oxford Economic puts it, there are few guarantees in life, but a nasty fight over the debt ceiling seems to be one. Like death and taxes.
The debt ceiling was last suspended under Biden in 2021, Trump suspended it twice, in 2017 and 2019, while Obama suspended in 2013, 2014 and 2015. In 2013, the government was shut down for 16 days after conservative Republicans attempted to de-fund Obamacare by leveraging the debt ceiling. An agreement to suspend the debt limit was passed within a day, which was when the Treasury was estimated to run out of money.
Note, the last time the debt ceiling was actually raised was in 2011.
If the Treasury runs out money, the government cannot be funded, leading to a shut down, but nor can the interest payments be made on government bonds. While Congress eventually made good in 2013, the US lost the AAA credit rating it had held for 70 years.
Not even the rightest of far right Republicans would be stupid enough to allow the US to default on its debt, particularly given the bulk is owned by China, which is why some resolution is always reached.
But not before much wailing and gnashing of teeth.
The current debt ceiling is US$31.4trn – a number so incomprehensibly large it makes the whole thing rather meaningless. So large that it will never, by any stretch, be paid back. But it does have to be serviced, and any increase in the ceiling increases the interest payment burden on the federal budget – a burden already much greater since March 2022 when the Fed started hiking.
According to Citi’s projections, Congress will need to raise the debt ceiling by August – and possibly earlier – to satisfy all obligations. That projection depends heavily on the size of tax payments this week.
The tax season ends on Tuesday, notes Oxford Economics (income tax payments due) and as the refund data roll in it could alter the expected timing of the “drop-dead date” for lawmakers to raise the debt ceiling. Oxford previously estimated the Treasury would run out of both the ability to issue debt and the cash to meet all obligations sometime in late July or early August. However, the refund data for this week could pull the deadline for raising – or suspending – the debt ceiling into June.
The rhetoric around the debt ceiling hasn’t been encouraging, notes Oxford, and the risks of a very nasty fight, a temporary breach, or a sudden shift toward fiscal austerity are increasing. A swing to austerity that repeats the errors of lawmakers in the wake of the GFC is an increasing downside risk to the economists’ forecasts.
House Speaker Kevin McCarthy recently cited a proposal to raise the debt ceiling for one year, but which would roll back domestic, non-defence spending to 2022 levels. This is a non-starter with Democrats, setting the stage for a potentially very nasty battle to either raise or suspend the ceiling.
And McCarthy does not have the unwavering support of all Republican members. It took 15 separate votes before his own party would agree to him being Speaker of the House.
There is speculation the Republican-controlled House will try to include limits to the budget over the next decade, rescind unspent covid fiscal stimulus, prohibit student loan forgiveness, repeal select green tax credits, and incorporate work requirements for federal social programs. This is clearly a non-starter for Democrats and wouldn’t pass the Senate, notes Oxford.
Note budget bills require only a 50% majority in the Senate, not 60%, and the Vice President would back the Democrats with her casting vote.
Financial markets are taking notice of the enormous divide between the Republicans and Democrats. This week’s auction of three-month Treasury bills produced the highest yield since 2001. Three-month bills auctioned this week could mature around the drop-dead date for raising or suspending the debt ceiling.
Oxford Economics’ baseline forecast assumes the debt ceiling will be either raised or suspended. Citi places a very low probability on Treasury missing a scheduled debt payment.
However, Oxford’s subjective odds that it is a more protracted fight than anticipated are rising. Either the Democrats or the Republicans will have to blink first, and a scenario is emerging in which there is a sudden shift to fiscal austerity similar to the one that occurred under the Obama administration.
The implications for such a forecast are uncertain. To take an extreme example, if Treasury were forced to function this way through the third quarter, warns Oxford, it would require spending cuts of about –US$260bn to avoid a default. Cuts of that magnitude would make the recession the economists have already forecast far more severe, reducing September quarter real GDP by -6.5% annualised.
Should Democrats agree to the barebones of the Republican's proposal to roll back domestic, non-defence spending to 2022 levels, the impact on Oxford’s baseline forecast would be minimal as it accounts for little of nominal GDP.
However, it would still likely push the unemployment rate higher and raise the odds of a recession. More aggressive fiscal spending cuts would have a bigger impact on GDP and increase the recession's severity and duration.
To muck about with a debt ceiling when a recession is already on the cards is not sensible politics. But we’re well aware sensible politics has not been America’s strong suit over the past few years. Until November 2024, the Republicans hold a slim majority in the House and the Democrats hold the Senate by that one casting vote, and never before have relationships been so fractious.
Stand by for potential financial market volatility as D-Day approaches.
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