The US debt ceiling was created in 1917 when Congress passed the Second Liberty Bond Act as the costs of World War I ratcheted higher. It is the statutory limit on the amount of US federal debt the country can have on the books. Before 1917, each loan or bond was approved as they were taken out. With the ceiling, a limit was set for how much could be borrowed that required congressional approval to increase the total amount.
Since 1917, the US government has raised or suspended the debt ceiling over 100 times; since 2001, this has happened 20 times. Hence, the debt ceiling doesn’t limit debt in any understandable sense of the term, nor does raising it increase debt or fundamentally change capital markets.
Late in 2023, the US will likely hit the next debt ceiling. As that limit draws near, the US Treasury will slow and eventually cease to increase the amount of bonds in circulation. It can still issue new debt to refinance maturing bonds because this won’t increase the outstanding debt. The US Treasury can also take “extraordinary measures” to extend how long it can continue paying its bills.
Unfortunately, if a shutdown occurs, government employees are the ones who feel the most significant burden. During these periods, non-essential workers are not paid, and many departments close their doors. Furloughed government employees receive unemployment benefits while waiting for a new debt ceiling solution, and once reinstated, they receive all of the back pay. It isn’t great for those affected over the short term. Still, due to receiving unemployment benefits and all back pay, some government employees take in additional income as a result of the shutdown period.
But the biggest misnomer is what happens to the US economic system. Prepare to be underwhelmed: a US Government shutdown due to reaching the debt ceiling hasn’t historically made Treasury yields spike, and no government shutdown has ever triggered a bear market. But that won’t stop politicians from using the topic as a wedge point on TV and in newspapers to encourage action and add urgency to the debate.
Thankfully, debt ceiling standoffs aren’t bearish to capital markets, but they sometimes hit sentiment and can contribute to market volatility. Remember, the US has never defaulted on its debt. Not once. We also know that the US debt ceiling can be used as political leverage, which makes it much easier to recognize that the perception associated with hitting the debt ceiling is nowhere near the reality media sources want you to imagine. This framework is helpful because the difference between perception and reality is a significant driver to moving markets higher—A widely discussed fear of a false factor is a positive to capital markets.
I do not pretend to have a solution that will fix the debt ceiling debate, but I am fond of a theory presented by Alan Reynolds and Steve Stein to deal with the issue. I took the liberty to word pinch and rephrased a portion of their 2021 printed article:
“There is a much more innovative way to oppose endless budgetary excess. Instead of trying to block appropriations already passed, Congress could offer legislation that covers all the bills the United States has incurred. But this bill would need to include a key condition: If the publicly held national debt exceeds a certain percentage of the current annual GDP (currently about 125%), the Federal Reserve would be restricted from holding more than a stated percentage of that debt (now about 25%). At that point, the Fed’s hoard of Treasury IOUs could not grow faster than the American economy that undergirds the debt and bankrolls the required interest payments.
The proposed “Debt Monetization Limit” would ensure that the Federal Reserve’s enormous mountain of Treasury IOUs could never again grow faster than GDP. The Treasury could still offer to sell all the bonds and bills needed to fund expenses that exceed revenues. But legislators could no longer count on the convenience of having a friendly central banker handy to mop up massive issues of Treasury securities if they proved difficult to peddle at home or abroad without offering a higher yield.”