The US debt ceiling: What to expect, how to respond
09 October 2013 | Markets and Economy
With the partial shutdown of the US government in its second week, a potentially more serious problem looms: By 17 October, the US Treasury will reach the federal debt ceiling, placing the US government at risk of systemic default for the first time.
We spoke with three experts from The Vanguard Group, Inc. on the political, economic and investment implications: Ann Combs, head of government relations, chief economist Joe Davis of the Investment Strategy Group and Ken Volpert, head of the taxable bond group.
What exactly is the debt ceiling?
Ann Combs: Simply put, it's a congressionally mandated limit on the amount of public debt the Treasury can incur. Currently, it stands at just less than $17 trillion. Later this month, the Treasury will reach that borrowing limit. Interestingly, the United States and Denmark are the only two Western countries that have such a restriction in place.
What's sometimes overlooked in the debate over the debt ceiling is that refusing to raise the borrowing limit wouldn't actually reduce the debt. It would, instead, stop the Treasury from meeting many of its financial obligations – obligations that have already been authorised by Congress. In essence, the government could spend only what it takes in through taxes and other revenues. Some bills, such as interest on the federal debt, could continue to be paid, but many others wouldn't. We would be in a state of partial default.
The federal government has never formally reached the point where the Treasury lacked funds to pay its bills, although it came close in the summer of 2011. A near delay in raising the debt ceiling resulted in the first-ever downgrade in the nation's credit rating and a sharp drop in the stock market. Congress then raised the debt limit, and the crisis passed. We expect the debt limit to be raised again, but probably not until we bump right up against the deadline.
What's the significance of a government default?
Joe Davis: It would be uncharted territory for the United States, and it would be very dangerous – not just for America, but for our trading partners and the rest of the world.
First, let's consider the immediate economic impact. Many federal services would be curtailed and government employees beyond those already affected by the current shutdown wouldn't get their paychecks. At the same time, millions of people who are on the receiving end of federal payments – ranging from Social Security beneficiaries to government vendors and contractors – would cut back on their spending as those funds dry up, and that would have ripple effects throughout the economy. A recession and financial crisis certainly wouldn't be out of the question.
Second, a default would seriously shake global confidence in the US government, and it would damage the credit rating of US Treasury bonds. That would likely make it more difficult for the federal government to borrow money in the future. It's rather like when an individual consumer misses a credit card or mortgage payment – your credit rating takes a hit, and your options for future borrowing are narrowed.
What does this mean for the bond market?
Ken Volpert: As strange as it may sound, concerns about the government’s ability to deal with the debt ceiling in the short run leads to lower Treasury yields and higher Treasury prices. This is because riskier assets (for example, stocks, high-yield bonds and emerging market bonds) would likely decline in price due to concerns about the impact of a broader government shutdown on the US and global economies.
If the government actually is prevented from borrowing above the debt ceiling limit after 17 October, we’d expect the government to do whatever is necessary to make sure all principal and interest payments are made on US Treasury debt. This would require prioritisation of payments to eliminate any budget deficit to stay at the debt limit, which, as Joe noted, would lead to some major pain to the economy in the areas where the payments are withheld.
If the government does miss interest or principal payments – which we do not expect to happen – we would anticipate significant forced selling by many central banks and institutional investors. That would lead to significantly higher Treasury yields and lower bond prices. This would have very dire economic consequences domestically and internationally. Again, we do not expect this to happen.
How should investors respond in the meantime?
Ken Volpert: We do expect this situation to be resolved before the 17 October deadline. If investors feel the crisis has passed, we could see an uptick in stocks and riskier bonds along with a decline in Treasury bond prices.
We recommend that investors not try to market-time in this environment. Even the hint of an agreement or resolution, which could happen at any time, could lead to significant price movements in the markets. Investors should look through this short-term crisis and keep their focus on maintaining their long-term asset mix at their target levels of stocks and bonds.
From a policy standpoint, what's the solution?
Joe Davis: Raising the debt ceiling is essential. But it's equally important – ultimately, perhaps, more important – to put in place structural spending and revenue reform that brings down our national debt levels over time.
There are two ways to bring the federal budget into balance, and neither of them is politically popular: Reduce spending and increase revenues. The good news is that there are a number of very credible plans on the table to put the country on a sustainable fiscal path, and some of them have significant bipartisan backing.
Is bipartisan agreement possible in this environment?
Ann Combs: In the past, there has always been a last-minute compromise resolution, and we've avoided going over the brink. I believe the senior figures in Congress and the Obama administration genuinely recognise the importance of avoiding default and are sincere about wanting to reach agreement.
One problem is that neither side is willing to compromise – yet. Republican leaders in the House are under intense pressure from a small group of very conservative members (and their supporters around the country) to stand firm. They want to tie continued funding for the government and any increase in the debt limit to major changes in the Affordable Care Act, or the ‘Obamacare’ health insurance law. That is a non-starter for the president and Democrats, so the Republican leadership is trying to switch their demands from health care to deficit reductions and entitlement reforms. On the Democratic side, President Obama, with the full support of the Democratic leadership in the House and Senate, is standing firm on his ‘no negotiations’ stance, confident that the Republicans will blink and pass a clean debt limit increase. There's been a sense among Democrats that the public is basically on their side in this budget battle, and that’s stiffening their resolve.
There’s one other obstacle to serious long-term fiscal reform, and that’s the fact that federal revenues have been on the upswing all year. Ironically, the fact that the government’s operating deficit has declined sharply means there’s less pressure to address the long-term structural debt through the kinds of reforms Joe talked about.
There may be a way out. An extension of the debt limit and funding for the government at current levels combined with a genuine commitment to entitlement reform and a relaxation of budget sequestration may provide enough for both sides to feel their concerns were addressed. It may take a couple of short-term extensions to work out such a deal so we could face several more months of uncertainty.
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