Understanding What’s at Stake in the Debt Ceiling Debate

Amid bank failures, interest rate hikes, and concerns about a potential recession, America seems intent on reviving its production of everyone’s least favorite political soap opera: the debt ceiling debate.

Congress has once more engaged in a game of chicken over raising the debt ceiling. Republicans want to attach a series of budget cuts and referendums to any ceiling raise. President Biden and congressional Democrats have demanded a “clean” bill, with the Biden administration warning they will not sign anything else.

No one seems ready to budge, and we are projected to run out of money to pay bills in early June.

Complicating matters, the public doesn’t really understand what the fuss is all about, with only 42% of Americans able to explain the debt ceiling correctly. This ignorance enables the reckless politicization of a mechanism never intended to be weaponized in the first place.

But with Treasury Secretary Janet Yellen warning over the weekend that failure to raise the debt ceiling will spur a “steep economic downturn,” the stakes grow higher by the day. Let’s break down the debt ceiling and why this drama matters… a lot.

Defining the Debt Ceiling Debate Jargon

The conversation typically centers around government spending whenever fights over the debt ceiling break out. But those discussions often include casual (sometimes inaccurate) invocation of specific terms.

The first idea introduced is usually the deficit. This represents the total amount of money owed by the US government to its creditors. The deficit grows when the government’s spending outpaces its revenue generation, necessitating borrowing. The debt ceiling establishes a limit on the amount of money the US can borrow.

Politicians, media commentators, and voters alike often falsely contend that raising the debt ceiling equates to an increase in government spending. They blame increasing the amount of debt the government may accrue for the swelling deficit.

This is not true. Congress controls government spending and subsequent deficit growth through the budget and additional legislation throughout the year. Raising the debt ceiling does not increase that spending. Instead, it ensures the government can borrow enough money to meet obligations established by Congress while making regular payments on our debt.

Think about it this way: the deficit is like the amount of electricity you consume in a given month. Raising the debt ceiling is like paying your bill so the electricity stays on in the month to come. Paying that bill does not increase the electricity you have consumed or will consume next month. It’s you making good on the promise you made to the electric company when you set up service.

Just like failure to pay your electric bill will leave you in the dark, failure to raise the debt ceiling will turn the lights off across DC and the nation. All but essential services will shut down. And all because we would rather toss political punches than address valid concerns in the appropriate context from an informed perspective.

How Deficit Spending Impacts the Economy

Depending on who you ask, the deficit either plays a central role in maintaining a country’s economic health or stymies growth. Proponents argue that running a deficit can help stimulate the economy. This is especially true during downturns, as government spending attempts to make up for decreases in private sector and consumer spending.

This approach to fiscal policy may also decrease unemployment and increase disposable income by encouraging business output. Known as the multiplier effect, this boils down to the economy-wide ROI on government expenditures. For instance, if for every $100 the government spends, the GDP increases by $150, then the spending multiplier would be 1.5x.

Fiscal conservatives insist that a balanced budget generates more benefits. Deficit spending can increase inflation as cash is injected into the economy – certainly a concern right now, even with CPI edging lower last month. They further contend that debt accumulation amounts to wealth transfer, with debtors (the US government and its taxpayers) redistributing wealth to creditors (those who hold government bonds). They warn that deficit spending today builds a tab future generations will have to pay.

The most common refrain from opponents of deficit spending, however, is easily the government/household budgeting analogy. It basically comes down to, “If I have to balance my budget, the government should, too.”

This notion is entirely detached from reality. To quote Olivia Munn’s character on Newsroom, “Balancing your checkbook is to balancing the budget as driving to the supermarket is to landing on the moon.”

It’s just not that simple. If you, for instance, tightened your budget by cutting out a monthly subscription to Netflix, you might miss out on the latest season of Bridgerton. If the government cuts out spending on specific programs, people can literally die as access to healthcare, financial assistance, and community resources are compromised.

Reasonable people may debate the wisdom in running a deficit, but that ultimately has nothing to do with the debt ceiling debate or this moment in time. That’s a whole different bag of economic consequences.

Immediate Ramifications of Failing to Raise the Debt Ceiling

Whether your hero is Keynes or Smith, hitting the debt ceiling means academic disagreement is moot. We’ve already received the bill, and it’s time to pay up. Except failure to pay these particular bills won’t land you in the kitchen, washing dishes. It’ll impact the wallets of all Americans.

To be clear, raising the debt ceiling does not directly impact the economy. It does not increase spending or affect the cost of borrowing money. The government spending reflected in reaching our debt ceiling has already been priced into the markets. Not raising the debt ceiling, on the other hand, does have a direct impact.

If we default, the ramifications mount quickly. Yes, government services shut down. In the meantime, the government also risks missing interest rate payments on their debts (i.e., bond investors). This default makes it much more likely that credit agencies will downgrade US debt, which makes borrowing money more expensive for the government – and, in turn, consumers.

In this specific scenario, the Biden Administration’s Q3 analysis projects that a protracted default would lead to a 6.1% decrease in the country’s GDP. Even a short default would result in a loss of -0.6%.

This isn’t a hysterical characterization of the stakes. If anything, it’s a narrow read of the consequences. We would not be defaulting because of an inability to pay. It comes down to a willingnessto pay. And the blow that would deal to global market confidence cannot be understated.

Beyond Default: The Significance of Debt Ceiling Debate Optics

Wait, wait, wait, you might be saying. Technically speaking, we’ve never actually defaulted. This time will be no different.

Aside from that not being guaranteed, it also might not matter. We don’t need to default to reap the consequences of dysfunction in Congress. Just the debate can throw the markets into a tailspin.

Historically, raising the debt ceiling was largely a non-event. Established in 1939, Congress typically increased the ceiling well before we came anywhere close to a default. It wasn’t until a 1995 reversal of the so-called “Gephardt Rule” that it turned into a political football. Even then, it took until 2011 for brinksmanship to look like anything but hot air.

Today looks very different. Incalcitrant idealogues hold the debt ceiling hostage – the equivalent of a toddler’s temper tantrum with much higher stakes. The markets, adjusting to this new reality, have become far more reactive to posturing. They no longer need us to hit the debt ceiling to panic. All it takes now is the possibility we might.

The timing of this particular round of debt ceiling debates makes the situation more perilous. Sarah House, senior economist at Wells Fargo, put it this way:

[W]e don’t even have to actually reach that X date without a deal. But if it looks like it’s coming very close to the end of that period, you could still see a lot of collateral damage in the economy, particularly given the toxic political environment and perhaps not a lot of optimism that it might actually get done.

If you go back to 2011, for example, consumer confidence over the summer when we were having a very similar split in terms of Congress and the White House, you saw a confidence plunge that summer, you saw the stock market decline essentially 17% in just a matter of weeks. So you don’t even need to actually default on the debt for there to be real damage in the economy and particularly given that the overall picture is already getting increasingly fragile. It wouldn’t take a lot to accelerate that downward momentum if you did see another contentious debt-ceiling debate.

In fairness, the initial volatility witnessed in markets during a debt ceiling standoff rarely proves durable. While the S&P 500 finished flat in 2011, it was up 13% by the year’s end following the 2013 debt ceiling fight.

But in each of those years, interest rates were incredibly low, making the stock market an attractive option for investors. Between an unprecedented pace of rate hikes over the past year, serious concerns about a global recession, and banking system uncertainty, investors are keeping their money on the sidelines.

Research demonstrates that debt ceiling debates slowed broad economic growth in the past.

With economic growth already hamstrung, the consequences of the debate stretching much further in 2023 could be dire. Indeed, the previously cited Biden Administration analysis found that US GDP could shrink as much as 0.30% from the debate alone.

Possible Debt Ceiling Solutions

The easiest way to avoid this chaos is a clean debt ceiling bill. This means legislation that raises the ceiling and nothing else. Given GOP resistance in the House and the letter signed by Senate Republicans vowing not to pass a bill without significant spending reforms, this presents the least likely path forward at this time.

So what’s a government to do? As it turns out, there are a couple – albeit controversial – options.

Invoke the Debt Clause

The first solution under consideration would include President Biden leveraging the debt clause in the 14th Amendment to unilaterally raise the debt ceiling. It reads:

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.

Scholars, economists, legal experts, and political analysts disagree on whether or not this would be legally permissible. Significant concerns tied to Article I, Section 8 of the Constitution and the constitutionality of the debt ceiling itself underpin President Biden’s stated reluctance to adopt this approach.

The only really relevant case law on the subject comes from 1935. We don’t have a modern test to lean on. With Supreme Court politics and integrity under a microscope in recent months, how they would resolve a question so steeped in partisan debate is difficult to say.

But Secretary Yellen also said over the weekend that this solution would likely spur a Constitutional crisis but would not aid in dodging significant economic damage. To this end, a constitutional solution seems like a legally perilous gamble with serious potential downside and limited upside.

#MintTheCoin

A second solution – as far-fetched as it is surprisingly seemingly legal – involves minting a coin. Not just any old coin. The coin to end all coins.

A $1 TRILLION PLATINUM COIN.

Sound nuts? We understand. But this hair-brained scheme could actually work. The idea relies on 31 U.S. Code § 5112(k), which reads:

The Secretary may mint and issue bullion and proof platinum coins in accordance with such specifications, designs, varieties, quantities, denominations, and inscriptions as the Secretary, in the Secretary’s discretion, may prescribe from time to time.

The argument goes like this: mint a platinum coin worth $1 trillion and use it to pay our debt. Originally floated as a solution in 1992, the idea of minting the coin gained real traction in the 2011 and 2013 debt ceiling standoffs, with #mintthecoin trending across social media platforms.

Legally speaking, few have found justification for shutting down the proposal. In fact, as Philip Diehl, 35th Director of the U.S. Mint, wrote in 2013:

In minting the $1 trillion platinum coin, the Treasury Secretary would be exercising authority which Congress has granted routinely for more than 220 years.

[…]

There are no negative macroeconomic effects. This works just like additional tax revenue or borrowing under a higher debt limit[.]

The law provides Treasury all necessary authority to pursue this course. I know this because I wrote the law and produced the nation’s first platinum coin. I’ve been through the entire process.

Theoretically, this means the coin is not, on face, an impossible idea. But sound theory does not a viable solution make, and sentiment surrounding the strategy is decidedly mixed.

… Or Don’t #MintTheCoin?

The proposal has drawn criticisms from all directions – some thoughtful, some derisive. Concerns about the impact of ramping up the money supply on already high inflation have some merit, though others contend that QE post-2008 proves the US is no Zimbabwe.

Still others feel the move erodes the already imperiled checks and balances among the branches of government, though one might point out that this particular debate revolves around degrees of dysfunction. But the impact of minting the coin on already pronounced partisanship certainly weighs heavy on the mind.

Secretary Yellen has questioned whether the Federal Reserve would even accept the coin. On both sides of the aisle, senators and representatives feel the coin would not solve the root of the recurring debt ceiling debate problem, putting a band-aid on a gushing artery.

A symptom of the nation’s financial and political illiteracy, recent polling indicates that 49% of voters have no opinion on the subject or didn’t know enough about it to say. They surely will once politicians start making it a talking point. But hey – the idea is still more popular than Vladimir Putin! (For now, at least.)

Could the coin be used to bypass the debt ceiling debate? Maybe. Should the coin be used? That answer is even less certain.

How Investors Should Weigh the Debt Ceiling Debate

Don’t. In most cases.

Short-term volatility spikes and losses are the most likely scenario here. That could prove problematic if you currently rely on your investment portfolio for income or have a much shorter time horizon to reach your financial goals. For most investors, though, portfolio recalibration at this juncture isn’t necessary. After all, betting against the stock market has historically been just as ill-advised as chasing returns.

One caveat to this calculus: safety plays. According to Modern Portfolio Theory, investors who spread their allocation across diversified asset classes minimize risk while protecting upside. Bonds traditionally serve as a “safe” investment that go up when riskier assets (like stocks) go down. But if volatility jumps because credit rating agencies have now downgraded the supposedly safe investments, that strategy might not work as well.

But panicking won’t help you. Speak to an advisor if you feel you need to adjust your portfolio. They will have the best understanding of your current holdings and goals.

And maybe contact your elected representatives. Tell them to stop messing with our money.

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