What happens when the US reaches its debt ceiling?

What is the Debt Ceiling

The US Government is like any other entity with a balance sheet. Over the years, it has consistently spent more than it earns, creating a budget deficit. This deficit is primarily financed by raising debt through the issuance and sale of US Treasuries, which are mostly held domestically. To keep spending in check, Congress has imposed a debt ceiling that requires majority approval to be raised periodically. This is unique, as most other developed countries don’t impose such limits on government borrowing.

Since the end of World War Two, the US Congress has raised the debt limit 102 times.

The Political Tug of War

The time has come to once again raise the limit; though, doing so will require bipartisan agreement — a feat complicated by recent political friction between both US political parties.

Often, Congress pairs debt-ceiling increases with other budget and spending measures, allowing lawmakers to negotiate multiple fiscal matters at once. This practice also shields them from the political backlash of approving a debt increase.

Both US political parties know that increasing the debt ceiling is crucial, so that’s not up for debate; the real issue is how they’ll go about reaching a negotiated agreement. The Republican party wants to package the debt ceiling increase with massive reduced spending, while the current Democratic administration prefers a clean increase with no extra terms linked to it.

Learning from the Past

Now, let’s take a trip back to 2011 when the US Government, on the 11th hour, almost ran out of money. On that exact date, Congress passed and President Obama subsequently signed a bill into law, increasing the debt ceiling. However, the uncertainty leading up to this decision caused the US’s credit rating to be downgraded by Standard & Poor’s from AAA to AA+. Financial markets didn’t take this lightly, as the S&P 500 fell nearly 17% between July 22nd and August 8th. Interestingly, during the turmoil, investors sought haven in long-dated US government bonds and gold, both of which increased in value.

What’s Happening Now?

More recently, the statutory debt limit was reached in January 2023, with Treasury Secretary Janet Yellen stating that the Treasury would continue operating using extraordinary measures. However, these measures are expected to run out as soon as June, with a significant (20%) probability that it happens before June 15. If the government manages to hold on past that date, it may survive on partial shutdowns and incoming lump sum revenues until October 2023. So, what are the potential outcomes?

• Raising it: Congress can raise the debt limit before the so-called “X date” (the date at which point the U.S. Treasury would no longer have the capacity to finance the government’s obligations).
• Suspending it: Congress voted seven times between 2013 and 2019 to suspend the debt ceiling for a set amount of time, rather than raising it. This allowed lawmakers to avoid signing off on a specific amount of additional debt, providing some certainty for the future.
• Not suspending or raising it: Should the Treasury’s cash balances be depleted and extraordinary measures exhausted, the Treasury would hit the debt ceiling. No one knows precisely how bad a U.S. default could get, but it would likely cause a financial crisis. The silver lining? Policymakers have a strong incentive to resolve the matter, even if it means compromise, since everyone has far too much to lose.

Our Honest Take

As long as the debt ceiling exists, expect these battles to persist for years to come. With benefit programs like Social Security and Medicare accounting for the largest category of the budget and projected to grow dramatically as the population ages, the situation won’t get any easier.

No one stands to benefit from a US government default on its debt, and history suggests that it’s extremely unlikely. Despite the highly partisan environment, Congress has always managed to find a compromise to extend the debt limit. That being said, brace yourself for short-term market volatility and heart-stopping headlines as the debt ceiling deadline approaches.

Remember, the key is to keep focus on your long-term investment plan. As long as we as a society continue to produce goods and services, markets will continue to trend upward over time. By focusing on a well-diversified and long-term investment strategy, you can ensure you withstand these short-term fluctuations and reap the benefits of long-term growth. After all, the 2011 debt ceiling debacle led to a quadrupling of the S&P 500, showing the importance of playing the long game when holding a diversified pool of company ownership.