Last quarter was defined by calm and optimism in the markets. For most of this year market volatility has been low and value opportunities for new investments were limited. That may change over the next month. A government shutdown started last night and markets will react with an increase in volatility. I hope to take advantage of any panic that ensues by finding some excellent value stocks trading with significant margin of safety. We’ll wait, however, until the debt ceiling showdown passes in late October. A debt default would create long-term market harm by initiating some level of credit freeze and lowering consumer and business demand. To counteract that possibility, we’ll want cash on hand to buy if the market takes a significant tumble. The good news is that the current shutdown may lower the risk of debt default.
As Alec Phillips put it in a recent research note for Goldman Sachs, “If a shutdown is avoided, it is likely to be because congressional Republicans have opted to wait and push for policy concessions on the debt limit instead. By contrast, if a shutdown occurs, we would be surprised if congressional Republicans would want to risk another difficult situation only a couple of weeks later. The upshot is that while a shutdown would be unnecessarily disruptive, it might actually ease passage of a debt limit increase.”
Some House Democrats have also come to believe that a shutdown might be the best way forward. It provides, in their eyes, a relatively safe space for the showdown Republicans clearly want to have. It is visible and dramatic enough that the GOP will feel public pressure. It is, however, low stakes enough that the damage to the economy, though real, will be modest.
There is a catch to this theory: the calendar. The shutdown began 17 days before we hit the debt ceiling. That means there’s not a lot of time for political pressure from the shutdown before the debt ceiling arrives. That time frame, however, should be adequate. One reason Republicans in Congress are not more concerned about the debt ceiling is that markets and business constituents have yet to strongly react. At some point during the shutdown, probably sooner than later, market volatility will increase and Republicans will start getting calls from Wall Street and the CEOs of major companies.
If you have questions about what the debt ceiling is, and how it works, I’ve compiled some facts.
The debt ceiling is a self-imposed limit on how much the nation can borrow. Before 1917, Congress had to approve each new debt issuance. If it needed to borrow money for a specific project, it had to pass new legislation deciding on the bond’s maturity date and interest rate.
This became too burdensome once World War I hit. Congress slowly loosened the rules on individual debt issuances before removing them entirely in 1939. Still, it didn’t want to make borrowing open-ended. So Congress told the Treasury, “You can borrow this much money. Go figure out the best way to do it.” According to the Congressional Research Service, this “gave the Treasury freer rein to manage the federal debt as it saw fit … with maturities that would reduce interest costs and minimize financial risks stemming from future interest rate changes.”
Once we hit the debt ceiling, Congress goes back and raises it again.
The debt ceiling doesn’t control spending, but it can be used as a bargaining chip. It has no direct link to the normal annual budgeting process. Budgets are passed nearly every year that will require borrowing in excess of the debt ceiling limit. When Congress authorizes these budgets, there’s an implicit assumption that they’ll also raise the debt ceiling.
The need to raise the debt ceiling isn’t about future spending; it is about paying for spending Congress has already agreed to. Two budget votes take place in Washington: one to decide how much to spend (the budget) and another down the road to decide whether we want to pay for that committed spending (the debt ceiling).
If Congress fails to lift the debt ceiling before October 17th, the government will not be able to pay all its bills, which include everything from Social Security payments to wages for soldiers and park rangers to interest on the national debt. The government still takes in a lot of tax revenue, about $2.7 trillion this year. That could pay some (even most) bills. But deciding who gets paid and who does not is tricky, both legally and logistically.
One idea is that the Treasury can prioritize payments on things like soldier pay and interest on the debt. But the Treasury says it’s not equipped to do that. It processes several hundred million checks each year, and its computer system isn’t set up to pay in any other order than first come, first served.
Some legal scholars also say that if one person (say, a government vendor) isn’t paid so that someone else (say, a Medicare recipient) can be made whole, the vendor could sue the government for unlawfully prioritizing. That brings up a whole new set of problems.
While the Treasury takes in a lot of tax revenue during the year, it’s not like a worker’s stable paycheck that arrives in equal amounts every other Friday. It’s uneven. For example, in February, it took in $122 billion. In April, it took in $406 billion. So, short-term cash-flow problems, not total annual revenue, are what make a debt default unavoidable without raising the debt ceiling. This is also why the government still borrows from time to time when it’s running a surplus.
Denmark is the only other country with a debt ceiling and the Danes are practical about it. They’ve only had to raise their debt ceiling once since the early 1990s. Rather than a modest increase, the politicians nearly doubled it so that the issue would not come up again soon.