THE DEBT CEILING DEBATE:

FINANCIAL REALITY OR POLITICAL THEATER?

February 17, 2023

When Shakespeare wrote the line, “Neither a borrower nor a lender be,” it related to the finances of a royal household in his play, Hamlet. Some 400 years later, the statement is eerily relevant to the present federal debt ceiling debate. At a magnitude of $31.4 trillion, the debt ceiling represents 123% of our nation’s current gross domestic product (GDP). On a more individual basis, our current national debt equals $94,000 per U.S. citizen, or $247,000 per U.S. taxpayer.

In this report, The Mather Group LLC (TMG) will focus on the magnitude, sources, and outlook for the federal deficit, as well as analyze the current political debate that centers on linking any increase in the debt ceiling level to limits on future spending initiatives.

Of course, it is in the interest of both political parties to avoid a potential Treasury default. In fact, Congress has successfully acted 78 times since 1960 to permanently raise, temporarily extend, or even revise the definition of the debt ceiling limit. Hence, there is little reason to believe that such success will not occur in this current round of negotiations.

The Origin and History of the Debt Ceiling

Let’s start by framing the debt ceiling debate within some historical context. Created in 1917 relative to World War I financing efforts, the debt ceiling simply caps the amount of federal debt that can be issued by the U.S. Treasury to fund current congressional appropriation levels. It is not—as many assume—a separate source of funding approval for future spending bills.

The debt ceiling has not been an initiative driven primarily by either political party, despite some current political rhetoric to the contrary. More specifically, as shown in the graphic below, increases in the debt ceiling have continued to occur since 1980, irrespective of which party controlled the White House or Congress. Thus, it has been, with only a few exceptions, a bipartisan funding strategy in support of expanded government spending programs.

The level of the debt ceiling simply reflects the historic difference between revenues the government has collected in the form of taxes and fees and its outlays in the form of annual congressional appropriations, such as for defense spending. As shown in the graphic below, the federal budget has run an annual deficit since 2000, which has driven the need for increased levels of the debt ceiling.

The shaded lines below represent past recessions, so some of the major funding shortfalls of this century resulted from government deficit spending driven by the dot-com crash of the early aughts, the global financial crisis (GFC) in 2008-2009, and the economic and market downturn at the outset of the COVID pandemic. In addition, significant unfunded tax cuts and the global war on terrorism following 9/11 have also contributed to these growing deficits.

Possible Ramifications of a Continually Increasing Debt Ceiling

If left unchecked in its growth, the federal deficit faces two near-term threats that could undermine U.S. financial and economic stability. The first is a policy initiative by the Federal Reserve Board (Fed) arising from the GFC and then the COVID pandemic to force market interest rates downward.

As shown in the graphic below, these falling rates kept annual interest payments on outstanding federal debt relatively level for years, despite the fact that the amount of debt was still growing. With more recent Fed actions raising interest rates significantly to fight inflation, annual interest payments on outstanding debt are accelerating. In addition, the Treasury continues to replace older, lower-yielding Treasury bonds as they mature with higher-yielding ones, and this level of annual interest payments will inevitably continue to rise, even if the amount of debt were to remain unchanged.

A second threat is the potential unwillingness of foreign investors to hold increased levels of Treasury debt as the deficit continues its growth. As shown in the graphic below, foreign investors hold $7.4 trillion of U.S. debt, or 23.6% of the total. Japan is our largest foreign investor, holding 14.9%, with China holding 12.0%.

However, both Japan and China have continued to reduce their Treasury holdings in recent years, with Japan now at its three-year low. More ominously, China is at its lowest level of holdings since 2010. While Japan remains a buyer with historic diplomatic ties to the U.S., increasingly hostile rhetoric between China and the U.S. may portend a continued reduction in its holdings. Unfortunately, no replacement buyer of a comparable size to China exists.

Factors Underpinning the Debt Ceiling's Political Divide

Given the financial dimensions of the current Federal deficit, let’s explore some of the primary drivers of the political debate over a debt ceiling increase. Importantly, there have been several significant changes since the debt ceiling was last raised in 2021. First, the House of Representatives shifted to Republican control in the aftermath of the 2022 election, allowing a new fiscal agenda to emerge in replacement of the prior one. Second, there has been an increasing belief among some members of both parties that the recent trillion-dollar stimulus spending programs may have contributed to the current spike in inflation. Some members worry that the resultant Fed tightening now underway may result in an economic recession before inflation can be subdued. Hence, one perspective is that future spending programs must be frozen at their current levels, if not even reduced, to avoid any further inflationary pressures or more aggressive action by the Fed.

One potential pathway to exercising increased control over Congressional spending is by tying any increase in the debt ceiling to negotiations over the size and growth of future Congressional appropriations. This is the nexus of the debt ceiling debate now beginning among both parties in Congress and the current administration.

A significant financial challenge to these negotiations is the fact that 63% of the federal budget is already labeled as mandated spending (e.g., Medicare and Social Security) and is not subject to negotiation. A further 7% is required for interest payments on the federal debt, leaving just 30% of the budget as discretionary spending, the only amount subject to potential changes or reductions.

Strategic Resolutions Being Considered

While negotiations are in early stages and will most likely evolve over the coming weeks and months, listed below are just a few of the key strategies offered thus far.

Postpone the “due date” for the ceiling until September 30 so it coincides with the end of the government’s current fiscal year. This would enable the debt ceiling to be linked directly—perhaps even dramatically—to approval of a new federal budget.
Agree to short-term spending cuts (e.g., defense), which would limit the need for or the amount of any debt ceiling increase. Given that only 30% of the federal budget is discretionary in nature, the choices to be made in this strategy would be both limited and stark.
Agree to long-term spending cuts within some elements of mandated spending programs, such as Medicare, Medicaid, Social Security, or even the interest paid on the federal debt. Most likely impossible to achieve quickly, these would be seen as formidable decisions to make before the upcoming 2024 election.
Abolish the debt ceiling, drawing upon language found in the 14th Amendment, “The validity of the public debt of the United States shall not be questioned.” More specifically, this argument posits that congressional appropriations are not equivalent to a government bond, and therefore, are immune to any ceiling.

Should negotiations stall or even fail, the outcome could be dramatic for our economy. Moody’s Analytics, a division of the credit rating agency, has modeled the potential outcome of a Treasury default that only lasted a few weeks. Their model suggests such a default would result in a drop of 4% in GDP, a loss of six million jobs, and a 33% decline in the equity markets. In summary, a major recession would be one result. In addition, a credit rating downgrade of Treasury debt could also occur, as followed the last debt ceiling standoff in 2011.

What could the Treasury do to prevent or forestall a default in the event of a credit ceiling deadlock? In advance of June 2023, when it is presumed the debt ceiling will be pierced, some actions might include:

Prioritize payments among creditors and beneficiaries of Treasury spending. However, if payments to Social Security recipients were to be delayed, as an example, a significant loss of consumer confidence could result.
Defer payments on Treasury securities such as Treasury bills (still a technical default). However, when this occurred in 1979, the delay resulted in an immediate increase of 0.6% on the yield for 30-day Treasury bills, so any interest savings were only illusory.
Withold contributions to Federal employee retirement funds, which, in essence, is another form of deferred payments.
Issue higher-yielding Treasury bonds, the proceeds of which could be used to fund maturing bonds. Unfortunately, this would result in higher interest payments in the future, so no net savings would result.

As this is only the beginning of the debt ceiling debate, further—and perhaps even more innovative—strategies may emerge in the coming weeks and months. These will include those not only from elected officials in Congress and the current administration, but also from within the Treasury as well. As more clarity becomes apparent, TMG will update this report for you.

It is important to note that, despite this period of political volatility, your financial plan plays a critical role in helping you maintain progress toward achieving your financial goals. Your trusted TMG advisor is ready to respond to any questions or concerns you might have, and to help assure that your financial plan remains both timely and actionable. Please reach out to your advisor for guidance at any time.

Sources: Bloomberg; Congressional Budget Office; Federal Reserve Board; General Accounting Office; Moody’s Analytics; Office of Management and Budget; National Bureau of Economic Research; Reuters; S&P Global Corporation; US Bureau of Economic Analysis; US Treasury; Wall Street Journal

The Mather Group, LLC (TMG) is registered under the Investment Advisers Act of 1940 as a Registered Investment Adviser with the Securities and Exchange Commission (SEC). Registration as an investment adviser does not imply a certain level of skill or training. For a detailed discussion of TMG and its investment advisory services and fees, see the firm’s Form ADV on file with the SEC at www.adviserinfo.sec.gov, or on the firm’s website at www.themathergroup.com. The opinions expressed, and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. The opinions and advice expressed in this communication are based on TMG’s research and professional experience and are expressed as of the publishing date of this communication. All return figures and charts shown are for illustrative purposes only. TMG makes no warranty or representation, express or implied, nor does TMG accept any liability, with respect to the information and data set forth herein. TMG specifically disclaims any duty to update any of the information and data contained in this communication. The information and data in this communication does not constitute legal, tax, accounting, investment, or other professional advice. Investing involves some level of risk. Past performance does not guarantee future results.