It took 15 ballots, but eventually, new Congressional leadership was elected. Urged by President Trump to “play tough” on the debt ceiling, the House immediately set out to provoke a crisis. Another one. For a few months, the Treasury has gotten by on extraordinary measures like delaying contributions to pension funds. But that margin will soon be exhausted, maybe as soon as June 1. The edge of the precipice now in sight, negotiations are starting. But what, exactly, is the debt ceiling? Is it really that important?
The debt ceiling is a provision of US law that limits how large the public debt outstanding can be. It is a legacy of World War I, when those in favor and against entering the war reached a compromise which, by limiting funding, restricted the degree of involvement in the conflict. Defined as an absolute dollar amount, as opposed to a percentage of GDP, it must be raised periodically just to keep up with inflation and growth, with larger increases needed when deficits swell due to wars, recessions, pandemics, or whatever reason. Congress has raised the ceiling dozens of times, sometimes without a fuss, sometimes contentiously. It is an American oddity. Only Denmark has a similar cap defined in local currency, the Danish Krone, but it always raises the ceiling well before it is reached.
To uniformed ears, refusing to raise the debt ceiling may sound fiscally responsible. Unfortunately, it is the opposite. It is reckless. Fiscal rules restricting budgets are indeed reasonable, and in fact, many countries have them, like the Eurozone Stability and Growth pact, which limits deficits and debt as a percentage of GDP, although in practice the rule has been adhered to inconsistently. But making spending consistent with tax revenues is not what refusing to raise the debt ceiling means. It means blocking the Treasury’s ability to borrow as needed to pay bills due now, for expenses approved in the past. It is a threat to cause chaos, damage the country’s financial reputation and the Dollar’s international reserve currency status. It should be unthinkable.
Yet, there have been multiple instances when a House of Representatives controlled by one party has used the threat of default as a bargaining tool against a President from the other. The most recent crises, in 2013, 2011, and 1996 were provoked by Republican-controlled houses against Democratic Presidents, whereas in 1985 it was the other way around. In recent times, Democrats have voted against raising the ceiling, including then-Senators Biden and Obama, but those no votes were symbolic, not escalated to crisis levels.
Financiers know that default is a serious matter. Jamie Dimon of JP Morgan says that the bank is preparing a “war room” on the debt ceiling, and that creditworthiness is “not to be played with.” Warren Buffett opines that “failing to raise the debt ceiling would be a massive mistake, the most asinine act that Congress has ever performed.” Former Fed Chair Ben Bernanke referred to a debt ceiling crisis as a “self-inflicted wound”. This view was shared in 2019 by President Trump. While in office, he referred to the nation’s credit as “sacrosanct” and declared “I can't imagine anybody ever even thinking of using the debt ceiling as a negotiating wedge.”
Previous debt crises have led to shutdowns and the country flirting with default. However, as the national debt and interest rates rise, the sums involved are getting bigger. What would a default mean in practice? Banks, insurance companies and investment funds rely on US Treasuries as the safest assets. Even a short-lived breach would lead to credit downgrades and hit the stock market. Multiple economic sectors and markets would go into wait-and-hold mode. If the situation was not resolved, runs, panics, a severe financial crisis and macroeconomic downturn seem all but unavoidable.
In any country, sovereign default and deep recession go hand in hand. But the United States has even more to lose, because of the special status that US Treasury bonds still have—despite the historic credit downgrade by Standard and Poor’s in the 2011 episode—as international reserve assets. It is not just US financial institutions that rely on government debt. Foreign central banks, i.e., the foreign equivalents of the Federal Reserve, keep their international currency reserves mostly in US Dollars. Furthermore, insurance companies, banks, and a whole host of other financial institutions anywhere from Latin America to East Asia, see the US Dollar as the obvious choice when it comes to a safe store of value. What does this do for the American economy? A lot. It is an exorbitant privilege. When there is a financial crisis in the United States, even home grown like in 2008, global investors rush to buy, not sell, US debt, effectively giving the United States government an enormous low-interest loan, making it cheaper to launch monetary and fiscal stimulus programs. In most other countries, the opposite happens. Domestic crises lead to capital flight. Global investors sell bonds, and call loans, forcing governments to pay higher interest and tighten belts to keep at least some investors around. Not even the British Pound, which sat on the metaphorical reserve currency throne until about 100 years ago is now safe from market runs, as we saw in 1992, and last Fall, when a financial storm effectively brought down the Truss government.
Critics sometimes argue that fears are overblown, because the Pound was replaced by the Dollar and no currency or asset, not the Yuan, nor the Euro, nor Bitcoin, nor gold, appear poised to dethrone the greenback. However, the role of the Dollar does not have be filled by only one currency or asset. Diversification away from the dollar can occur with multiple currencies splitting the market share. Those who minimize the severity of the situation also point out that the United States has already had debt ceiling standoffs in 1985, 1996, 2011 and 2013, and the sky did not fall. Does that not show that fears are overblown? Not in the least. Previous crises caused a historic downgrade of the country’s credit rating in 2011. Moreover, like an unhealthy habit that may not cause a major health crisis in the short run, or a toxic behavior in a relationship, for a while it may seem like nothing is happening, until a tipping point is reached where everything changes. If the belief spreads globally that US debt is risky because it periodically seizes up due to political dysfunction, things will not be the same. It takes a long time to build a reputation, and an instant to lose it. And once lost, it takes a long time to repair it.
As a native of Spain, a country with historical bankruptcies that most recently endured debt pressures during the Euro crisis of the 2010s, I remember vividly how much worse a recession can be if the government’s credit is in question. Thus, I am bewildered and saddened to see political dysfunction reach such levels of irresponsibility. Students of history, however, are not so surprised. The early Spanish bankruptcies occurred in the 1500s, when the Spanish Empire was arguably at its peak, well before the decline and fall. In the 1500s, it was disagreements involving King Phillip II and nobles at the Cortes that prevented taxes from being authorized and debt payments being missed. It is also striking that events that old still came up in the 2010s when, Bill Gross, the “bond king” at PIMCO, an investment firm, mentioned them in an interview about the ongoing Spanish debt troubles. Bankers remember these things. For a long time.
So, what is happening now? The House has passed a list of demands, including, among others, limiting spending growth to 1% per year, repealing the student debt forgiveness program, take back some unspent COVID-19 stimulus funds, raising work requirements for SNAP recipients, reducing IRS funding, and revoking some green energy subsidies of the Inflation Reduction Act. These are the demands for raising the ceiling temporarily, with plans to come back and use the same threat again next year.
Politically, independently of the merits of the demands, the debt ceiling should not be a negotiating wedge. If the House gets even some of what it wants out of this threat without paying a political cost, it is no secret that it will continue to use this tactic in the future to extract more concessions from the White House and Senate. On behalf of the voters who elected them, neither can accept this.
For a political cost to be paid, it is likely that some of the ugly consequences of not allowing the government to pay its bills have to be seen and felt again. Unfortunately, the country has to get closer to the edge of defaulting. Before a default, there will be some sort of shutdown, and that early stage of the crisis is already very unpleasant. Some government services, deemed non-essential, stop functioning. Those government workers are furloughed. Companies that do business with government entities may see disruptions. A cloud of uncertainty appears over the economy, getting darker by the day. Currently, the banking crisis that has been contained by the FDIC, may flare up, since the Treasury is ultimately backing the FDIC and its recent pledges to guarantee deposits over $250,000. All those problems will raise the heat on both sides to lift the ceiling temporarily and eventually reach a compromise. That is basically what happened in 2011 and 2013. The House, in the end, got some spending cuts, but not the big prize, the repealing or defunding of Obamacare. The sequester cuts may or may not have slowed down the recovery from the Great Recession, but the experience left a bad taste for everyone, at least for a little while.
Other options available to the Biden administration, which may be exercised if negotiations stall, would respond to the debt ceiling trick with another trick, taking advantage of loopholes, like minting a trillion Dollar coin, issuing bonds while playing with semantics of what is principal versus interest (to effectively issue more debt than is declared), or invoking the 14th Amendment to unilaterally repeal the debt ceiling. Such gimmicky solutions, however, venture into uncharted legal waters and can lead to Constitutional crises. In general, tricks like the filibuster, gerrymandering, and the debt ceiling threats themselves are symptomatic of poor health in a democracy. They may not break the letter of the law but they clearly break tradition and the spirit of the law, going against what ancient Romans called “Mos Maiorum”. There are downsides to going down this road, although that does not mean these options should be off the table. Their downsides need to be weighed against the economic and political downsides of the other alternatives.
Once more, this quirky legacy from World War I is precipitating a political crisis with the potential to inflict major economic damage. A flame has been lit where no fire should be allowed. The immediate challenge is to put it out before it burns our economy or our democratic and political institutions. Then, the challenge will be to eliminate the debt ceiling altogether.
