The Debt Ceiling

What is the time limit for the debt ceiling?

Officially, the Treasury reached its debt ceiling on May 16.  However, the government has been able to conserve cash and free up some capacity.  This has bought Congress some time to reach a consensus, but because the government operates at a deficit, we are eating through the capacity and, despite cash conserving measures, will reach the debt ceiling by August 2. 

What are Republicans and Democrats saying?

While both Republicans and Democrats are in agreement about the need to raise the debt ceiling, they are in strong disagreement about just how to do so. In fact, that is the reason we have witnessed weeks of toiling over this debt ceiling issue, even now, just days away from the deadline set forth for coming to a decision. More specifically, Republicans believe that in dealing with this unsustainable level of debt, government must make enormous efforts to cut spending, not just raise taxes. Democrats, although presumably of the same ideology as President Obama in wanting to raise taxes on higher income classes, are distraught over the President’s discussion of cutting spending on such programs as Medicare and Medicaid.

What if the debt ceiling isn’t raised? Will the government shutter itself?

If Congress does not agree to raise the debt limit, it will be the first time in US history that the US faces technical default. Technical default, as opposed to actual default, is not characterized by failure to pay interest or principal on debt. Depending on who you are talking to, the implications of this notion vary greatly. While the Democrats tend to believe that we have no choice but to raise the debt limit, in order to avoid a financial meltdown, Republicans aren’t so convinced. They are more of the belief that regardless, interest payments would be paid on our debt, and therefore, it would not be as large of a crisis as Democrats purport, but that it is truly representative of our country’s larger spending problem and the need to cut government spending overall. We are of the belief that the government will not collapse. Rather, it will continue to operate, but it will be required to run on a more balanced budget or surplus, so as to conserve and/or replenish its funds.  To accomplish this feat, the government will prioritize its expenses and pay the ones deemed most critical first.  

In the event that resolution is not reached, what effect would this have on the stock and bond markets?

While it is impossible to tell exactly how the market will respond, it is clear that the global financial scene would certainly feel the effects of US default, even if it is just a technical default. We do not anticipate that an unsuccessful resolution of the debt ceiling would be viewed fondly by the international credit and stock markets.  However, much of the weakness in the markets of late may be in part attributable to concerns over the debt ceiling.  Therefore, we believe that some of this risk may be priced into the markets already.  A successful and timely solution to the debt limit would almost certainly be viewed positively by the markets, and market reaction to a defined plan would depend largely on the resolution’s blueprint, especially in terms of monetary size and where particular cuts are made.

Will the US Treasury stop making interest payments?  Are my Treasury bonds safe?

We believe that interest payments will be a top spending priority for the government, should it reach its debt ceiling.  If it does reach its ceiling, it will be paramount for the government to demonstrate its commitment to servicing debt to our international creditors so that they will continue to lend to us in the future. 

What programs will get paid first?

In agreement with a recent piece by Alec Phillips of Goldman Sachs, entitled “US Daily: Q&A on the Debt Limit,” we believe that after interest payments, critical defense programs, Social Security, and Medicare will be paid first.  After these programs, it is difficult to determine the exact order of the other smaller programs, as President Obama has a considerable amount of discretion over the prioritization of funding.

What about state and local governments?

As the federal government moves to conserve cash and cut expenses, it becomes more and more likely that aid programs to the states and to local authorities will be increasingly strained and at risk of being cut.  Additionally, should the US Treasury’s credit rating receive a downgrade from the major ratings agencies, this will trigger downgrades of municipal bonds that have been pre-refunded with Treasury and Agency obligations.  Furthermore, several states currently have triple-A credit ratings.  A downgrade of the US Treasury and the uncertainty of federal aid will most likely lead to reviews and downgrades of these states’ credits as well.