The Debt Ceiling
It seems like every few years there is a political standoff related to the debt ceiling. It is making headlines once again as around mid-August would mark an approximate “x date” for when the U.S. Federal Government would default on its debt if the debt limit is not raised or suspended. As is well known by all politicians involved, an actual debt default is projected to be a catastrophic event for not only the United States but also markets across the globe. A default would jeopardize the United States’ ability to borrow at low rates and would ultimately lose its gold standard for financial stability.
Although gloomy at first, the degree of problem that a U.S. default would cause is so severe and well-known that all political actors are incentivized to avoid this outcome. The failure to deal with this issue is expected to result in any political leadership being voted out of office if they are seen as part of the problem. This is the reason why financial markets have grown accustomed to this standoff dynamic. It is an easy fix to either raise or suspend the debt limit and it is in both political parties’ incentives to act accordingly.
As noted by Moody’s, a well-known major rating agency, in a recent paper:
- “This scenario is consistent with the long, arduous history of agreements on the debt limit, and it is fitting given the bipartisan nature of the financial obligations the debt would cover.”
- “Getting the debt limit legislation across the finish line will surely be messy and painful at times, causing heightened volatility in financial markets. But in this scenario, lawmakers ultimately get the job done before there is economic damage,” Zandi and colleagues wrote.
We have been monitoring the situation for our clients. So far, this is nothing new. In 2011 and 2013, there were similar political standoffs before the issue became ultimately resolved. The debt ceiling has been raised over 70 times historically since it was created in 1917. For many clients, the total amount of risk is dampened by a sizable allocation to fixed income. In 2011, for example, when S&P downgraded the United States, U.S. dollar-denominated bonds rallied in response for months.
Finally, although the U.S. does have a large debt load, it should be noted that when compared to Europe and Japan, it is in line with most developed countries. Meanwhile, the innovation, relative birth rate, and the fact that the USD is the world’s reserve currency all bode well to support the United States as a relative place for safety over the long run.
All in all, despite the political turmoil we are seeing in the headlines, financial markets have grown accustomed to the standoff. We expect this to be resolved in a similar fashion to the previous debt ceiling debate, with it being raised or suspended in the final hour.
Written by: Thomas Leahy, CFA®