As the 1 June deadline set by US Treasury Secretary Janet Yellen looms, a deal that prevents the U.S. from defaulting on its debt seems inevitable. President Joe Biden appears set to follow in the footsteps of his predecessors, negotiating his way to victory. But, was this always inevitable? The media and political rhetoric surrounding the saga would suggest not. However, looking back at the past few stand offs and how they were resolved tells a different story.
What is the debt ceiling?
The debt ceiling is managed by the U.S. Department of the Treasury, and is the total amount that the United States government is authorised to borrow to fund its existing budget commitments. It does not allow any new spending but simply enables governments to finance pre-existing obligations that Congresses and Presidents have made in the past. It was first established in 1917 to enable the Treasury to borrow up to the debt limit without congressional approval, which allowed it to streamline financing efforts for World War I.
Today, government spending mainly comprises Social Security and Medicare Benefits, military salaries, interest on the national debt, tax refunds, and other payments. These expenditures steadily grow over time due to increases in the population, inflation, and new government commitments such as better healthcare for an ageing population.
The U.S. government currently runs a budget deficit, meaning its revenue (raised through taxation) is not enough to cover its expenses. As a result, the government is required to borrow money to fund the difference. This isn’t a rare occurrence and the last time the government ran a surplus (where revenue raised through taxes exceeded expenses) was in 2001 under President Bill Clinton. Congress is authorised to suspend or raise the debt ceiling so the government can meet this gap and pay its debts.
With a fixed cap (or ceiling) on the amount of debt the Treasury is able to spend, Congress must pass a bill to increase this limit whenever it’s reached. The U.S. Government hit its current US$31.4 trillion borrowing limit in January and U.S. Treasury Secretary Janet Yellen warned that the country would run out of cash sometime in June if the debt ceiling was not raised before then.
Why does it matter?
Like failing to pay off a credit card, negative consequences would follow if the US defaulted on its debt. In a recent press conference, commenting on the scenario of a US default, Federal Reserve Chairman Jerome Powell suggested, “We’d be in uncharted territory ... and the consequences to the U.S. economy would be highly uncertain and could be quite averse.” Specific economic repercussions could include nearly 8 million job losses (according to Moody’s) and delayed payment of federal benefits such as Social Security. A recession would likely follow and the stock market would be at risk of plunging.
Similar to credit card default, the US would then be considered higher credit risk and face higher borrowing costs in the future. Fitch, one of the top three credit rating agencies (along with Moody’s and Standard & Poor’s), placed the US “AAA” on “rating watch negative” last week. Fitch currently assigns the US Treasury a AAA rating (the highest available), signalling the country has the lowest expectation of defaulting and an exceptionally strong capacity for payment on financial commitments. Fitch’s change in outlook reflects the possibility of a first-ever default amid ongoing uncertainty surrounding the current debt ceiling debate, and signalled the agency would downgrade US debt if a deal to raise the debt ceiling was not reached in time.
History Doesn’t Rhyme, It Repeats
This is hardly the first debt ceiling standoff to happen in Washington. Since the 1950s, both Democrats and Republicans have pursued legislative battles over the debt ceiling. Typically, it is used as a leverage mechanism to further their agenda or paint the other party as financially irresponsible. Most often, it goes down to the wire, and an agreement is always reached before any dire economic consequences occur. Since 1960, Congress has acted 78 times to permanently raise, temporarily extend, or redefine the definition of ‘debt limit’. This is not a partisan process and has occurred 49 times under Republican presidents and 29 times under Democratic presidents.
As reported by CNBC, President Trump has urged Republican lawmakers to allow the U.S. to default on its debt unless Democrats agree to aggressive spending cuts. This is in stark contrast to the position he took just three years ago when sitting in the White House as Commander-in-Chief. In 2019, then President Trump called the debt ceiling a “sacred element of [his] country”, and told White House reporters “I can’t imagine anybody ever even thinking of using the debt ceiling as a negotiating wedge.” Even as the deficit surged under President Trump’s watch due to significant tax cuts, congress voted in favour of raising the debt ceiling with no budget-cut preconditions and bipartisan support three times. At the time of the 2020 election, the national debt exceeded $27 trillion, the fastest rate of increase in the national debt of any modern American president.
The debt ceiling was raised seven times under President Obama. Like President Biden, President Obama faced significant opposition from the Republican party to get this done. On 5 August 2011, as negotiations went down to the wire and the country arguably came its closest ever to default, the U.S. experienced its first-ever downgrade of the country’s AAA credit rating by Standard & Poor’s to AA+. However, a deal was eventually reached and such a default was avoided (although S&P has not raised the rating back to AAA). Similarly, just as Biden cancelled his trip to Australia last week for a Quad meeting (with Australia, India and Japan), President Obama was pulled out of an appearance at the APEC summit in Indonesia in 2013 to deal with a budget crisis. This was also resolved, with the US again successfully raising the debt ceiling.
The debt ceiling has become an issue for almost every American president to some extent. Republican President Ronald Reagan was responsible for raising the debt ceiling the most by any American President, by a significant margin. Over the course of his two term presidency, Reagan raised the limit a staggering 18 times, with $935 billion turning into $2.8 trillion. Republican President George H.W Bush only raised the debt ceiling four times by just 48%, but he only served one term. During Democratic President Bill Clinton’s eight years in the White House, the debt limit was raised by a relatively modest 44% from $4.1 trillion to $5.6 trillion when he left office. However, this wasn’t an entirely smooth run, with Clinton withdrawing from the APEC summit in Japan in 1995 to solve a debt ceiling dispute. During his two terms in office, Republican President George W Bush almost doubled the debt ceiling from $5.6 trillion in 2001 to $11.3 trillion in 2009.
Much Ado About Nothing?
Just like previous debt ceiling battles, the media would have you believe that default was imminent, a recession was likely, and chaos would follow. However, history would suggest that lawmakers always manage to reach a deal in time. Both political parties appear to recognise the gravity of such a default, and use the debt ceiling as a negotiating tool to further their political agenda. In fact, there are already early signs of progress, with the White House releasing a statement advising that an agreement had been reached between President Biden and congressional leaders to raise the debt ceiling in exchange for certain spending cuts. President Biden referred to the agreement as a “compromise, which means not everyone gets what they want.”
An Investor’s Perspective
The most successful investors throughout history have made a conscious effort to largely ignore the political and macroeconomic environment and instead focus on the key factors influencing their individual investments. This has been the case with Warren Buffett, Joel Greenblatt and Howard Marks each of whom realised the folly of predicting the future, particularly regarding political events.
Another such example is Peter Lynch, who once said “If You Spend 13 Minutes A Year On Economics, You've Wasted 10 Minutes.” Ignoring politics and macroeconomics certainly didn’t interfere with Peter Lynch’s enviable track record leading Fidelity’s Magellan Fund. In his 13 year tenure between 1977 and 1990, Lynch turned the $18 million fund into a $14 billion fund, with an average 29% annual return through the period, more than doubling the S&P 500 average return of 13%.
While progress seems to have been made, we haven’t quite seen the back of the debt ceiling drama yet, and there’s no doubt it will dominate headlines again in the future. But don’t let the news affect your investment philosophy and the next time a “debt ceiling standoff” occurs, the best thing you can do for your investment portfolio is simply ignore it and focus on what matters.
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.