Welcome to Finance and Fury. Debt ceilings, at the moment there are many media pundits warning about the US defaulting on their debt and the fallout that would follow, being a complete economic meltdown. We are going to do a deeper dive into this in today’s episode.

  1. As all the drama around the debt ceiling is sure to further highlight concerns about the US being a waning financial power and the USD being the global currency reserve
  2. Plus – The global economy has been in a pretty fragile place over the last three years, so throwing doubts over the creditworthiness of what is seen as the safe haven for the global financial system can create further instability in markets

What is going on and what is a debt ceiling  

  1. Think of it as an upper limit set on the amount of money that the US government can borrow
    1. In 1939, Congress passed the Public Debt Acts which set a limit on total accumulated debt over all kinds of debt instruments by the government – aggregate debt limit of $65 billion in 1941
  2. Skipping forward to the start of 2023 – The federal government reached its previously set debt ceiling of $31.4 on the 19th of Jan – so this has been dragging on for over 4 months now
    1. Whilst the debt ceiling legally caps how much the U.S. can borrow to pay, the Treasury Department has since been using what they call “extraordinary measures” along with its current cash flow of tax revenues to keep the government’s obligations paid – as well as paying for the government’s costs – but their ability to continue this has come into question, and the 1st of June is seen as the deadline
      1. At the time of recording, no deal has been made but it is highly likely that one will be reached by the time this episode comes out – they will end up negotiating a bill to increase the debt ceiling
      2. But looking at any deal when reached is not the point of the episode – but to focus on the debt ceiling and the problems that come from this
    2. How did it get this bad? How has the debt ceiling gone from $65bn to $31.4 trillion in 82 years? An increase of 48,208%
    3. Since yearly spending by the federal government exceeds tax revenue, the U.S. has accrued tens of trillions of dollars in debt, almost all of it in recent decades.
      1. But on top of this, past debt defaults on both principal but interest costs have been staved off through issuing more bonds, i.e. getting into more debts
    4. To help facilitate staving off the inevitable and admitting that the Federal government is bankrupt and can never repay their debt obligations – Congress regularly passes a measure that allows the U.S. Treasury to increase the amount it can borrow
      1. But this is congress – where both sides love to grandstand – so this issue has become a political lightning rod, setting off debate over the nation’s fiscal responsibility – when Democrats are in charge, Republican’s can block votes to increase the debt ceiling – and vice versa – but this is what is happening now
    5. The debt ceiling has been raised approximately 84 times since 1962 – however, the debt ceiling has never been reduced, even though the public debt itself may have reduced.
      1. Beyond the current issues with the debt ceiling – Congress will continue to need to increase the debt ceiling every year moving – after all, The CBO said in its latest report that it projects the gross federal debt will grow by $19.6 trillion by the end of 2033 – $51 trillion dollars of Federal government debt – not including any of the state or local government debts
    6. It is likely that the Republicans will get some of their wishes granted by the Democrats – political tick for tack
      1. So, the debt ceiling will probably be raised to make sure that the Federal Government doesn’t default on their debts – but it is still possible that they do – and the government shuts down – similar to 2013 or 2018 – the only difference is that during these periods of shutdowns, the interest costs of the US debt holdings was due – unlike it is in June
      2. The US government shutting down due to a debt ceiling isn’t an issue – is has happened many times – but the US being unable to fund their interest repayments on their debts due to not being able to raise more debt to cover this cost is the issue – as it is seen as a technical default on their debts – all $31.4 trillion
        1. But it isn’t the end of the world as we will see – as the debts will still be owed to the counter parties, it more or less as if they missed a mortgage repayment on their home

Why does the US debt matter so much, beyond the size of if – Well the US debt is viewed as a long ultra-safe investment

  1. confidence is the key here – For America, along with the global economic, this would be the loss of confidence in that the US will always pay its financial obligations
    1. Their debt, long viewed as an ultra-safe asset, is a foundation of global commerce, built on decades of trust in the United States going back to the Brenton Woods days of the 1940s – default could shatter the $24 trillion market for Treasury debt, cause financial markets to freeze up and ignite an international crisis – but this is the worst possible outcome
    2. Regardless – the 10 year US bond is the go-to safe haven for investors along with financial market theory – after all, the bedrock of CAPM is the using the 10 year US treasury bond as the risk free rate – if this rate increases, it changes the whole world of valuation models –
      1. Beyond this – whenever a financial crisis emerges, even one that originated in the US, the US dollar is still see as the go-to haven for investors
        1. This is what happened in 2008 – which was a financial crisis that originated in the US
        2. Due to being the global reserve currency – there is demand due to many OPEC nation treaties and other commodities being priced in USD for trade
      2. If the United States were to pierce the debt limit without resolving the dispute and the Treasury defaulted on its payments, the value of the USD could drop due to the uncertainty and the fear.
        1. The psychological ramifications of this would be huge – where investors fear, they flee to the USD, but this is loses value compared to other currencies, it becomes a guessing game of where to store the value of assets – this is where currencies like the AUD could actually benefit – but at the expense of the US and US dollar based investments
      3. But in the US – If they default on their debt obligations – it could have further ramifications beyond the money markets – which could further impact financial markets and individuals lives – before we get into this, it is a very low probability that the US would actually default on their debts – find out soon – but if they do
        1. The economy could slow –
          1. If the US does not lift its debt ceiling, it will not be able to borrow more money – and it will quickly run out of funds to pay for public benefits and other obligations.
            1. Given the increase on the US economy from government spending compared to private enterprise, the reduction in government spending as a component of GDP could slow their economic growth
            2. This also means they would have to cease their welfare payments and support to people – reducing people dependent on the system’s ability to consume and pay their bills – this would not only have an impact on the economy, but also GDP through a reduction in consumption spending
            3. As the US government’s ability to pay for social programs, such as welfare is funded through government deficits, i.e. raising additional debts, without lifting the debt ceiling, this scheme would cease to exist without the government cutting back on other areas of spending, which like any government, they are almost incapable of doing
            4. Beyond this, the federal government also employs many people
          2. The White House came out with an estimate, and they assume that if the government cannot reach a debt ceiling agreement for a prolonged period, the economy could shrink by as much as 6.1%
            1. This is from the current administration – who wants an increase to the debt ceiling very badly – so this figure should be taken with a grain of salt – but regardless of the estimated reduction, there is likely to be some – be it 0.01% or 6% – which is probably based around the worst possible case scenario
  • But given the reduction in government spending and potential drop in consumer spending if welfare gets cut for a month or so, this could also tip the US further into a recession – but this is also very unlikely
  1. Mortgages rates may rise – a US default could lead to US mortgages along with mortgages in other countries to become more expensive and could cause unemployment to rise
    1. Why would problems in the US make mortgages more expensive other countries? When a government wants to borrow money, it issues a bond or an IOU. In the US, it is called a Treasury bond. An investor charges the government interest if it buys Treasuries.
    2. If the US government does not repay its debt or even pay the interest, it creates a psychological effect – where investors in other debt instruments can view other nations debts as riskier – as if they US can default, what stopping the Aus government from doing the same thing?
  • Investors could then demand a higher interest rate to buy government debt – or commercial debts backed by central bank purchases, such as notes from commercial banks –
    1. Interest rates on debt – be it your mortgage debt or public debt – they take their cue from how much risk is perceived and a US default would be a massive risk event and therefore all debt would become more expensive overnight – probably by a fraction of a percentage point – but if the US was to default – which is a small probability – it could increase mortgage rates along with yield rates on newly issued government debts
  1. Price inflation, particularly in the US could go up – forcing further interest rate increases – sinking financial markets further
    1. The US dollar is the reserve currency of the world – as the world reserve currency, there is a long list of important commodities that are purely traded in USD – such as oil, which is used to make petrol or diesel, which are used in all major transportations for goods, and wheat, which is ground into flour to make bread for food prices around the world – these are just two commodities priced in dollars
      1. If the US government defaulted – value of the dollar is expected to drop sharply
      2. If you own other assets outside of the US this can sound like good news – but it would mean investors in commodities suddenly panic – selling assets lowering their values – then suddenly markets have to reprice everything in economic terms it is a risk premium. You get a risk premium added to prices and therefore bread becomes more expensive – due to the risk of other nations increasing their risks of defaulting
    2. If food and fuel become more expensive, it would raise the cost of living for millions of people
  • If inflation rates all of a sudden increase in the US and across the world – this could force the Fed and other central banks to put up interest rates beyond what they are estimated to do – leading to further declines to bond markets and equity markets

In summary –

  1. It is not likely that the US defaults on their debt obligations – that $31.4 trillion dollars will still exist – at worst, they miss a repayment – not the first time – they did so in 1979 due to a technical glitch – after all, this is simply a spat in congress where they have the capacity to cover these costs, but it is simply congress, particularly the republican side using this is a barging chip to get some of their measures passed
  2. Whilst it is not likely to occur – this episode has been more of a what if – as at some point, the US will lose confidence in its ability to repay its debts, as they continue to accumulate
  3. In the modern era – the congress not passing a debt ceiling increase could be seen as another technical glitch – it is simply used as a bargaining chip by one party or the other to get some measures passes
    1. But if they do default – in the short term it could create some instability in financial markets –
    2. But in the end – it shows the fiscal irresponsibility of the largest government on earth – the larger they become, the more fiscally unconstrained they can become – where they can rack up over $31 trillion dollars of debt with little to show for it, as whilst government spending in the US is at an all time high, their place as a global economic power starts to diminish –
    3. Because the USD is the world currency reserve – it allows the US to increase their debt to levels that will never be able to be repaid – even in 100 years if they fully ceased all of their spending activity
    4. They spend at a greater rate than what the economy can provide at the federal tax rate – showing the fragility of this style of governance
    5. Getting more and more into debt whilst exporting their production and economic output potentials to other nations due to regulations – spells for disaster

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