Last week Congress was able to agree on spending cuts to temporarily prevent a government shutdown, but now they are refocused on the federal debt limit.

Unlike other developed nations, the U.S. government can’t borrow money without prior approval from Congress.  Once upon a time Congress had to approve each round of new debt issuance, but that process became too burdensome and Congress enacted a law during World War I that set an annual limit on total federal borrowing.

Typically Congress discusses the debt ceiling as part of the larger budget process, but an actual vote on the issue doesn’t occur until the level of debt is near or at the limit (well after the budget decisions that affect borrowing have been agreed upon).  Because increasing the debt ceiling usually involves a long, drawn-out debate, the Treasury has several “extraordinary actions” at their disposal to keep the government afloat while Congress hashes out the federal debt limit. 

Since 1995, the debt limit has been increased 12 times and in six of those instances the Treasury took one or more extraordinary actions to avoid exceeding the debt limit.  The process for the three most recent increases was expedited to support legislation passed during the financial crisis and recession; if you exclude those instances, then it becomes apparent that the Treasury’s actions may be “extraordinary” but they are by no means a rare occurrence. (For a more comprehensive history see this report from the U.S. Government Accountability Office.)

Once the Treasury exhausts all of their options, the U.S. would be forced to default on their debt.  The consequences of a U.S. default would be catastrophic and could very easily spark a global financial crisis worse than the one we just endured.  The U.S. would likely lose its Triple-A rating, which would cause a sell-off in Treasurys and higher interest rates.  Banks balance sheets would be clobbered by the decline in their bond portfolios and, consequently, financial market liquidity would dry up circa 2008-2009.  Meanwhile, the dollar – which has been the global reserve currency based on confidence in the ability and willingness of the U.S. government to pay its debts – would fall, creating an entirely different set of problems.

In my opinion, default is an unlikely outcome, but the situation should not be viewed lightly.  The longer the debate in Congress draws outs, the more nervous bond investors get and the higher interest rates rise.  If rates were to increase dramatically in a short period of time, then the U.S. economy could easily fall into another recession.  And this time the government would not be able to afford stimulus packages that prop up the economy.  

Congress has about four weeks before hitting the debt ceiling, but I believe an agreement will eventually be reached and the government will begin selling bonds again.  Of course, investors may require a higher yield on those bonds than they do now.  Some people point to the elevated rates on Greece, Ireland, or Portugal’s debt, but that isn’t an appropriate comparison.  Unlike these countries, the U.S. controls its own currency and, as is the world’s largest economy, has far greater fundamental capacity to repay debt.

Yields didn’t rise much when the government last hit the debt ceiling in 1995, and that could play out again if the bond markets believe this is a temporary political standoff that will be resolved quickly.  On the other hand, a growing number of investors are pessimistic about the U.S. ability to cope with its long-term debt (Bill Gross has been particularly loud recently).  Growing pessimism along with the end of the Federal Reserve’s second round of quantitative easing (QE2) sounds to me like a recipe for higher interest rates. 

Peter Lazaroff, Investment Analyst

St. Louis, MO

www.acrinv.com