In part one of a two-part series, Greg Valliere, AGF’s Chief U.S. Policy Strategist, discusses the politics of getting a debt deal done in the United States.
A once-unthinkable scenario – the United States exceeding its budget authority and defaulting on its debt – cannot be ruled out, as U.S. Congress faces an unprecedented fiscal catastrophe.
In part one of this special report, we will look at the politics and the various scenarios that are in play in Washington, and then we will examine the potential market implications if there’s a default or a debt downgrade.
The politics: It goes without saying that the U.S. political climate is dysfunctional; Democrats have a one-seat majority in the U.S. Senate and the Republicans a four-seat advantage in the U.S. House of Representatives. That has made it virtually impossible to get much done this year.
After several years of enormous spending increases, the Republicans are adamantly demanding restraint. They point to a total U.S. deficit that has exceeded US$31 trillion, and forecasters predict red ink rising by over US$1 trillion each year for the next decade.
Republican activists believe the only way to bring down deficits is to refuse to approve any more debt ceiling increases. A widely derided law requires Congress to raise the debt ceiling whenever it’s hit; the U.S. has never defaulted, but there was a close call in 2011 which was followed by a debt downgrade by credit rating agency Standard & Poor’s.
Both parties have been profligate and reluctant to raise the debt ceiling, but militants in the House are determined to reject a debt ceiling hike without accompanying spending cuts. Created in 1917, the legislative cap has to be raised by a majority vote in both the Senate and the House of Representatives.
That vote does not pledge any additional spending; it merely raises the limit the government can borrow to pay back commitments already agreed upon by Congress.
The debt ceiling was hit on Jan. 19 of this year – since then, U.S. Treasury Secretary Janet Yellen has used “extraordinary measures” to avoid default. Neither she nor any budget experts know when the “X date” –when the U.S. would actually default – would be hit. Yellen thinks it could be around June 1, although Treasury could muddle through until the end of June.
The options: First of all, there will not be any tax hikes that could raise revenues and delay the day of reckoning, when a default would occur if the U.S. fails to pay bondholders. Tax hikes are anathema to the Republicans, who will face another tax battle in two years, when many of the Trump tax cuts expire.
So the focus will be entirely on getting enough spending reductions to satisfy the House Republicans, who passed huge cuts several weeks ago. Somewhat surprisingly, U.S. President Biden has expressed a willingness to consider spending cuts such as curbs on federal welfare programs for people unwilling to work, rescinding Covid relief that the states haven’t spent and a cap on spending hikes, which will be a key element of any deal.
What if Congress can’t agree to deficit cuts in June? The 14th Amendment to the Constitution deals mainly with equal protections granted to citizens under the law. However, an obscure sentence 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.”
Yellen and other officials have argued that using the 14th amendment is a gimmick that would encounter a fierce legal push-back from Republicans, extending all the way to the conservative U.S. Supreme Court, which might be disinclined to support the amendment. Likewise, there’s little support for minting a US$1 trillion coin and spending the proceeds on keeping the government from defaulting.
There is one other wildcard—the Treasury could sell part of its enormous trust funds (including its social security trust fund) and may tell various government agencies to slow payments to contractors.
This could provide just enough funding to allow government to hit June 15 without default. This is crucial because major corporate tax payments come due on that date and if the Treasury meets its obligations, it could enjoy several weeks without crisis.
A surprising market reaction: We have thought that a catalyst for getting a deal done would be the financial markets, but the reaction – especially in the stock market – has been muted. We still think the threat to markets would become acute if current progress towards getting a deal done ends up stalling over the next few days.
Finally, what if there’s a default? The U.S. Federal Reserve could step in, although Chairman Jerome Powell has called that option “loathsome.” But the prospect of a global financial crisis – with a recession looming – might prompt a reluctant rescue by Powell.
From a political standpoint, the American public would be furious if there’s a plausible chance that Social Security cheques aren’t mailed out and if most of the 4.2 million U.S. federal workers are furloughed. Over 100 million Americans depend on Social Security and Medicare.
The easiest solution: That, of course, would be Washington’s favorite approach to a crisis – kick the can down the road. If there’s no deal by early June and a default looks likely, we think Congress will pass an extension – perhaps until the July 4 recess or the August recess – or perhaps until the new fiscal year begins on Oct. 1.
At the least, it may take several days from now to iron out all the details in a budget plan, and there will be plenty of conservatives and liberals who will adamantly oppose some provisions. So an extension could be the best of all options. Therefore, this issue may stick around for a while, to the markets’ dismay – with no default, but no resolution either – well into the summer.
Read part two: What Would a U.S. Debt Default Mean for Markets and the Economy?
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