The looming debt ceiling crisis

ARTICLE | May 26, 2023

The United States is facing a looming debt ceiling crisis, as Treasury Secretary Janet Yellen warned that the country could run out of cash as early as June 1st if Congress fails to raise or suspend the debt limit. The deadline could still shift to late July as tax revenues trickle in, but the risk of a disruptive scramble between the parties in Congress to reach a deal is increasing. 

Understanding the debt ceiling

The debt ceiling, also known as the debt limit, is a legislative cap set by the U.S. Congress on the total amount of debt that the federal government can issue. This limit applies to both public liabilities, which include Treasury securities held by investors, and internal government obligations, such as the Social Security Trust Fund. 

The debt ceiling was first introduced in 1917 during World War I. The primary goal was to provide flexibility to the Treasury Department for financing the war effort while simultaneously maintaining congressional control over borrowing. Since then, the debt ceiling has been raised or suspended numerous times in response to the evolving financial needs of the U.S. government.

The debt ceiling serves multiple purposes in the U.S. financial system. First, it limits the government’s borrowing capacity, which encourages fiscal responsibility and prevents unchecked spending. By requiring Congress to periodically review and adjust the debt limit, the debt ceiling also promotes accountability and transparency in public finance. Second, the debt limit acts as a tool for Congress to debate and influence fiscal policy, as the need to raise the debt limit often prompts discussions on budget priorities, spending cuts, and revenue generation. Lastly, the debt ceiling serves as a signal to both domestic and international investors, demonstrating the United States’ commitment to maintaining a sustainable fiscal path. The perceived stability of the U.S. government’s finances underpins the nation’s credit rating and the global status of the U.S. dollar. 

Debt ceiling crises have occurred in the past, with the most recent instances taking place in 2011 and 2013. In both instances, Congress was eventually able to reach a deal. However, if the U.S. were to reach the deadline without a deal, the risk for financial markets and the economy would quickly escalate. It's worth noting that a debt ceiling crisis is not the same as a government shutdown, which occurred multiple times during the Trump administration. Government shutdowns occur when there is a disagreement on the budget (as opposed to the government's borrowing limit) and primarily affect government services and employees. 

Consequences of the debt ceiling crisis

The consequences of a debt ceiling crisis are manifold, affecting not only the U.S. economy but also the global financial landscape. 

Financial market and equity volatility

A debt ceiling crisis generates uncertainty and concern among investors, leading to increased volatility in financial markets. This heightened volatility can cause sharp fluctuations in stock prices, bond yields, and interest rates, making it difficult for businesses and households to plan for the future and creating a challenging environment for investment and economic growth. 

As investors grow anxious about the potential for a government default, they may respond by selling off equities, causing stock market indices to experience increased volatility. This can have a ripple effect on other financial markets and further dampen investor confidence. 

Disruption in the Treasury curve

The U.S. Treasury curve, which plots the yields on Treasury securities of varying maturities, is a benchmark for the broader bond market. During a debt ceiling crisis, the Treasury curve can become distorted, as investors may demand higher yields for short-term Treasury bills due to the perceived risk of default. This disruption can impact borrowing costs for businesses and consumers alike, ultimately slowing economic activity. 

Credit rating downgrade

One of the most significant consequences of a debt ceiling crisis is the potential for a downgrade in the U.S. credit rating. As seen in the 2011 crisis, a downgrade can result from prolonged political gridlock and a perceived lack of fiscal responsibility. A lower credit rating can lead to higher borrowing costs for the U.S. government, businesses, and consumers.

International confidence in the U.S. dollar

The U.S. dollar serves as the world’s primary reserve currency, and its status hinges on the perception of stability and reliability in the U.S. government’s finances. Debt ceiling crises undermine international confidence in the U.S. dollar, potentially leading to a decline in its value and causing disruptions in global trade and finance. 

Delayed payments on commitments

In the event of a debt ceiling impasse, the U.S. government may be forced to prioritize certain payments over others, delaying disbursements to beneficiaries, contractors, and other entities. These delayed payments can cause economic hardships for individuals and businesses that depend on government funds, further exacerbating the crisis’s negative economic effects. 

Potential recession and unemployment increase

A prolonged debt ceiling crisis can lead to a reduction in government spending and a tightening of credit conditions, ultimately increasing the risk of a recession. As businesses face higher borrowing costs and reduced consumer demand, they may be forced to cut back on investment and hiring, resulting in increased unemployment and a downward spiral of economic activity. 

Scenarios of default

The consequences of a government default on its debt could be even more severe. In a recent shock model produced by RSM US LLP, two different scenarios were tested to form projections as to what may happen in the event of a technical or actual default.

A technical default, defined as an extended period of nonpayment of some or all U.S. financial responsibilities, could double the current unemployment rate to nearly 7%, tip the economy into a full recession within six months, and result in a more persistent bout of inflation accompanied by a deterioration in the fiscal condition of the economy. 

An actual default, in which the government stops paying its obligations altogether due to a lack of funds, would be an economic catastrophe. Unemployment would likely surge above 12% in the first six months, the economy could contract by more than 10%, and inflation could soar toward 11% over the next year. 

In both scenarios, the credit score of the United States would suffer a decline, the stability of the dollar would be at risk, and the expense of issuing debt for both the private sector and the government would increase.

Reducing vulnerabilities

Households and small businesses are particularly vulnerable in the event of a failure to reach a compromise on the debt ceiling. The economic disruptions and uncertainties that follow can impact their access to credit, financial stability, and overall well-being. However, households and small business owners can take several steps to reduce their vulnerability to debt ceiling issues and mitigate the potential impact on their finances. Here are some strategies to consider:

1. Build an emergency fund. Having a cash reserve can help households withstand financial shocks, such as job loss or reduced income during a debt ceiling crisis. Aim to save at least 3 to 6 months’ work of living expenses in an easily accessible account. 
2. Pay down high-interest debt. Reducing debt levels, particularly on high-interest credit cards or loans, can improve a household’s financial resilience by lowering monthly debt payments and freeing up cash for other expenses. 
3. Diversify income sources. Households can explore additional income streams, such as part-time jobs, freelance work, or side hustles, to reduce reliance on a single source of income and increase financial stability. 
4. Review and adjust spending. Regularly evaluating household budgets and cutting back on non-essential expenses can help families better manage their finances during periods of economic uncertainty. 
5. Maintain a strong credit score. Ensuring a good credit score can improve access to credit and potentially secure better interest rates, even during times of financial stress. 

This article is intended to provide a brief overview of the looming debt ceiling crisis. It is not a substitute for speaking with one of our expert advisors. For more information, please contact our office.