Treasury Secretary Janet Yellen recently announced that by October the government will come up against its legal debt limit. Some in the media have interpreted this to mean that Washington is “running out of money,” while others have warned of a government “default.” The first characterization is technically true. Without Congressional action to increase the debt limit, much spending will have to halt. But to call it default is simply misleading. All that the debt ceiling prevents is the issuance of net new debt. Because making a payment on the existing debt reduces the total amount outstanding, it will make room under the existing ceiling to issue new debt to raise the funds to make the next payment. There will be no default.
Every investor must keep these points in mind. He or she ought also to remember that debt ceiling “problems” are an old game that are quickly resolved with little real lasting economic effect. Market participants know this history and are not likely to react strongly, if at all.
Washington frequently approaches the debt limit. The script goes something like this: The Treasury secretary warns of the approaching limit. Usually, Congress simply raises the limit, and the event passes largely unnoticed. But sometimes members of Congress use the event to political ends, and the country endures a few days of government shutdown before enough pressure builds on Congress to once again raise the debt limit and allow matters to resume as usual. During the shutdown (if any), the government carries on with what are considered “essential services.” Though there are often politics involved in determining what is “essential,” honoring government financial obligations is always considered essential. Thus, there is no default.
Seventeen times since 1977 the debt limit has led to a government shutdown. Usually, they last only a few days, during which some government offices close and many civilian government employees must wait for their pay (Washington makes up the back pay once it fully reopens). The longest shutdown by far lasted some 35 days under President Trump from late 2018 to early 2019 over the disposition of funds to build the president’s Border Wall. If the politics next month is especially thick, Congress will pass a small debt ceiling to reopen the government and then, when things calm down, pass a more significant debt hike to stave off for a while longer a replay of the 2018-2019 kabuki play.
Debt ceiling problems have never resulted in major policy changes. Markets have sometimes lost ground in the face of longer shutdowns, but have always recovered quickly, usually even before the shutdown ended.
In 2011, under President Obama, the credit rating agency Standard & Poor’s (S&P) took a shutdown as reason to downgrade Washington’s credit rating. No doubt S&P’s algorithms demanded the action, but it meant nothing in the real world. The practical purpose of a credit rating is to flag the likelihood of a default or a missed interest payment. But because the federal government issues the currency with which it meets all its obligations, there is zero chance of that ever occurring. “Printing” more money may result in an inflation that pays U.S. bond holders in dollars that have lost buying power, but Washington always meets its legal obligations.
For all the drama the media can make out of debt ceilings, for the long-term investor they are a non-event.