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Return of the Debt Ceiling: What It Means for Investors

Return of the Debt Ceiling: What It Means for Investors

The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party.

A deal that saw the Treasury’s debt limit suspended for more than a year will expire on March 15. When it does, the clock will start ticking. At some point in the late summer or early fall, Congress will have to decide whether to raise the limit—also known as the debt ceiling—or suspend it again. Failure to choose one of these options would mean the Treasury would not be able to borrow money to pay its bills, paving the way for a potentially chaotic and historically unprecedented default by the United States.

The debt limit is essentially a Congressional cap on how much the U.S. Treasury can borrow to pay for things like the military, Social Security checks and its existing debt. Congress originally imposed the cap to give itself more oversight over government spending. Once a routine matter, debt limit votes are now the subject of intense political fighting.

The deal to suspend the debt limit—struck in late 2015—temporarily removed arbitrary limits on government borrowing. When the cap returns on March 16, it is expected to be around $20 trillion. The U.S. hasn’t hit that level yet, so Congress won’t have to act immediately to avoid default. But a battle is looming.

“Extraordinary measures”

The Treasury is already preparing for the cap by juggling its spending priorities. On March 7, Treasury Secretary Steven Mnuchin sent a letter to House Speaker Paul Ryan (R-WI) indicating the department would begin taking “extraordinary measures” to avoid default. Such measures, which can include suspending the issuance of state and local securities and changing the way federal retirement funds are invested, have become more common as the fighting over the debt limit has intensified.

But these measures are temporary. They serve only to buy Congress additional time to decide on how to address the limit. How long these extraordinary measures can stave off default depends on a variety of factors, among them the pace of tax receipts. In his letter, Mnuchin noted that “honoring the full faith and credit of our outstanding debt is a critical commitment. I encourage Congress to raise the debt limit at the first opportunity so we can proceed with our joint priorities.”

Mnuchin will keep Congress apprised in the coming months about how long the department’s extraordinary measures will remain in effect, but eventually he will set a hard deadline by which Congress must act. Estimates vary as to when that will be, but analysts think it will hit sometime in late summer or early fall. At that point, the Treasury will need to borrow more to pay its bills or it will default.

Origins of the debt ceiling

Prior to World War I, Congress granted borrowing authority on a case-by-case basis. That changed in 1917, when Congress passed a law that helped finance the war effort by removing certain limits on the maturity and redemption of bonds. But it wasn’t until 1939 that Congress set an aggregate limit on virtually all public debt. The first limit was $45 billion.

Congress raised the limit several times during World War II, topping out at $300 billion in 1945. It was lowered after the war, and raised and lowered several more times in the 1950s, until the ceiling hit $300 billion once again in 1962. Since 1962, Congress has raised the debt ceiling nearly 80 times, including more than a dozen times in the last decade.

debt ceiling chart

Why do we even have a debt limit?

Originally, the debt ceiling was seen as a way for Congress to keep tabs on the government’s budget. Without it, the president could borrow and spend as much as he wanted, with little Congressional oversight.

In 1974, Congress started providing detailed outlines of exactly how the government spends its money. Some critics say this change rendered the debt ceiling superfluous. They point out that Congress needs to raise the limit only to allow the government to pay for things Congress has already passed a law directing the government to do. They also say the debt limit has become a political football that needlessly disrupts the markets and creates an unnecessary default risk.

Proponents of the debt ceiling say having Congress commit to voting on it acts as a disincentive to reckless spending. The idea is that voting to raise the debt is a public admission that the government is spending beyond its means.

Recent debt ceiling battles

In the past, raising the limit wasn’t controversial. Only in the last decade or so has it become a closely watched and highly politicized issue.

This has caused some scares. Congress’ inability to raise the debt ceiling in 2011 prompted a major crisis, taking the country to the precipice of defaulting on its debts for the first time in history. One credit ratings agency downgraded the U.S. debt rating, and the S&P 500 dropped 13% in the week before a last-minute deal was struck.

Subsequent debt ceiling battles have not been quite as dramatic, but uncertainty in 2013 and 2015 caused some market volatility and investor anxiety.

The 2017 debate

Where do things stand now? Congress could avoid a repeat of the 2011 drama by acting soon, perhaps by attaching a debt limit increase or suspension to another piece of legislation.

One possibility would be to bundle it with must-pass budget legislation coming up in April. The current deal to keep the government funded and operating—the subject of its own agreement that passed with the debt ceiling deal in 2015—expires on April 28. Congress must pass an extension of funding by then to avoid a government shutdown. That legislation could provide a vehicle to which a debt ceiling provision could be attached.

But finding a solution might not prove so simple. In recent years, conservatives in the House of Representatives have pushed to pair debt ceiling increases with corresponding cuts in government spending. Democrats, led by former President Barack Obama, insisted that any debt ceiling provision be “clean,” meaning that no conditions or other provisions should be attached to it. Democrats are expected to insist on such an approach again in 2017.

The divide in Congress has meant that House leaders have been forced in recent years to cobble together a coalition of moderate Republicans and a large group of Democrats to pass debt ceiling-related legislation in the face of conservative Republican opposition. Expect that dynamic to continue this year. That gives Democrats unusual power for the minority party.

While investors should watch carefully to see how this situation unfolds, Schwab recommends no action at this time. Congress has never failed to act on the debt ceiling in the past, and the U.S. has never defaulted on its debts. Even though debt limit dramas have become common, we continue to think Congress will act in time to avoid any serious consequences.

What you can do next

  • If you’ve built a solid financial plan and a well-diversified portfolio, it’s best to ignore the political noise and focus on your long-term goals. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
  • Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.
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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

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