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What the Debt Ceiling Debate Means for Investors

The Debt Ceiling and Your Portfolio
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Past debt-ceiling debates have had an impact on the markets. Schwab’s Mike Townsend explores what the next one could mean for investors.

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Janet Alvarez:

The debt ceiling is essentially the U.S. Treasury’s credit limit. And since its creation in 1917, Congress has regularly voted to increase it. But over the last few decades, those increases have come with increasingly heated debates that have roiled the markets. Congress is scheduled to debate it once again in 2017. Mike Townsend, vice president of legislative and regulatory affairs at Charles Schwab, joins us to explain what the debt ceiling is and what’s at stake for investors in these debates.

Mike Townsend:

One of the myths about the debt ceiling is that by raising it Congress is essentially granting itself license to spend more. You hear that all the time. But that’s not really true.

Janet:

You’re listening to the Insights and Ideas podcast, brought to you by Charles Schwab. I’m Janet Alvarez. Investors who remember the contentious debt ceiling debates of 2011 and 2013 have seen how it can have unexpected results, such as a downgrade of the U.S. government debt, or even a government shutdown. Mike Townsend will help us understand how the debt ceiling works, how the outcome of the recent election will likely shape the upcoming debate, and what investors should keep in mind.

Hi, Mike, thanks for joining us today.

Mike:

Well, great to be with you.

Janet:

So, Mike, our podcast today centers on the debt ceiling. And, you know, that’s a term many of us have heard of, but we don’t know exactly what it is. Can you clarify what the debt ceiling is precisely?

Mike:

Well, sure. The debt ceiling, which is also known as the debt limit, is a cap on how much the U.S. government can borrow. So the Treasury Department, which manages the country’s debts and cash flow, can issue new debt to pay the country’s bills as long as the total amount of debt stays below that cap.

The debt ceiling includes both publicly held debt and debts that the United States owes to itself, like to the Social Security and Medicare trust funds. Congress sets the limit and then needs to raise that limit periodically as the U.S. accumulates more debt. But one of the myths about the debt ceiling is that by raising it, Congress is essentially granting itself license to spend more. You hear that all the time. But that’s not really true. In fact, raising the debt limit allows Treasury to borrow money to pay its bills, but those are bills for spending decisions and other proposals that have already been approved by Congress.

So it’s not like Congress has a new blank check or something like that. They’re paying for things that have already been decided upon.

Janet:

So if these things have already been decided upon, why do we have a debt ceiling? How did the debt ceiling come about?

Mike:

Well, the debt ceiling actually is almost unique to the United States. There’s only one other country, Denmark, that has one. And we’ve actually had a debt ceiling in one form or another since 1917. And in 1939, Congress created the debt limit that exists today, which is an overall aggregate limit on all the national debt. One of the reasons the debt ceiling was implemented was to give Congress more oversight of the federal budget, kind of act as a check and balance on the executive branch’s borrowing. Today, the debt ceiling is also supposed to act as a disincentive to reckless spending. It essentially forces lawmakers to publicly admit that they are outspending our means. But with the national debt approaching $20 trillion, I guess I would say it hasn’t worked out as much of a curb on spending yet.

Janet:

So when is Congress poised to take on the debt ceiling next? You mentioned 2017. When does the debt ceiling come due?

Mike:

Well, the current agreement, which was reached, actually, in late 2015, suspends the debt ceiling until March 15 of 2017. Over the last few years, actually, Congress has been voting to suspend the debt ceiling rather than voting to increase it to a particular number, which I think is mostly out of embarrassment. I don’t think any politician really wants to cast a vote anymore that increases the debt ceiling to $21 trillion, $22 trillion, or beyond. Suspending the debt limit itself is actually an easier vote, sort of less political risk to your political opponents back home. But when the debt ceiling does come back in March of 2017, Congress will need to act pretty soon after that to avoid default.

Typically what happens is the Treasury Department can take a series of steps known as extraordinary measures to avoid default for a short time. These steps buy Congress anywhere from a few weeks to a few months to negotiate an increase. So I think we’re probably looking at a late spring, early summer time frame in 2017 for Congress to really be up against the wall to take action.

Janet:

When the U.S. government finds itself in extraordinary financial circumstances, such as an inability to pay its bills during a debt-ceiling stalemate, the U.S. Treasury takes what it calls extraordinary measures. These measures include a wide range of options. For example, to avoid a default and keep the government running in March 2015, Treasury Secretary Jack Lew suspended new issues of state and local Treasury bonds and delayed reinvestment in some federal workers’ retirement plans. Those steps helped keep the government running until Congress agreed to suspend the debt ceiling until March 2017.

Janet:

If we actually do go to the point of taking extraordinary measures, what impact would that have on investors?

Mike:

Well, I think, first, if you go to extraordinary measures—if Treasury is taking extraordinary measures, it means that there’s uncertainty about when and whether Congress is going to act, and that usually produces market volatility. And that volatility tends to increase as the deadline to defaulting on our debts gets closer. As to what would happen if the United States actually defaulted on its debt, again, I think no one is quite sure what would happen. There is no precedent. Most analysts paint a pretty dark picture.

Lower credit ratings, loss of confidence worldwide in our economy, stock market downturn, rising interest rates, drops in consumer spending, not to mention that the government would also have to hold back on payments to vendors, possibly even hold back on things like tax refunds or Social Security checks. So that’s not a road that anyone really wants to go down and explore exactly how it would play out.

Janet:

Can you describe some of those steps that the federal government and the Federal Reserve can take if Congress can’t agree on a new debt ceiling?

Mike:

Sure. You know, those extraordinary measures that the Treasury would take to avoid default are—they’re pretty complicated, they’re pretty obscure. They involve things like suspending investment in certain Thrift Savings Plan funds. That’s the retirement savings program for government employees. Treasury can also suspend the issuance of new securities and interest payments to the civil service retirement funds, to the postal service retirement fund.

But it’s important to understand that the government in that extraordinary situation would prioritize how it would order payments. And it would probably pick things like Social Security and Medicare to be at the very, very back of that list, and it would do simpler things that wouldn’t be quite so damaging as the first things out of the box. So that’s kind of how the government would approach that situation if we ever got to that situation.

Janet:

What are the consequences sort of over the long term for the economy and the markets of an ever-growing federal deficit?

Mike:

Well, you know, there’s not actually unanimity among economists on this issue. I think generally increasing deficits are thought to result in increasing interest rates, inflation, and if interest rates go up, that increases the amount of federal money that is going towards interest payments, and, ultimately, that could lead to higher taxes and cuts in government spending. But there are also some economists who believe that deficit spending can be used as a tool to spur economic growth. And I think we’re going to see this debate really tested in 2017 and beyond, in the coming years.

Janet:

The U.S. debt ceiling has been raised, in one way or another, more than 100 times since its inception in 1917, when the government needed more money to fund America’s fight in World War I. Over the following decades, increases to the debt ceiling had become mostly routine, until 1996, when a change in how the ceiling was raised led to a lengthy political fight that largely shut down the federal government.

To resolve the debate and end the shutdown, Congress agreed to raise the debt ceiling to $5.5 trillion, from $4.9 trillion. By the time of the heated 2011 debate, the debt ceiling had reached $14 trillion. And when it was suspended in 2015, it stood at just over $18 trillion.

Janet:

As you know, we have a new president-elect at the helm, and we’re facing new uncertainties as a consequence. How does that change or impact the debt ceiling debate?

Mike:

Well, I think there’s no question that we’re facing a variety of uncertainties with President-elect Trump. In terms of what he wants to do and probably more importantly how he wants to prioritize what he wants to do. I do think the debt and the debt ceiling fight that will come up fairly early in his administration is definitely one of those uncertainties. On the campaign trail, Trump didn’t talk a lot about the debt and the deficit, and I think that’s partly because, you know, he comes from a business background, a real estate background, in which debt is something you manage strategically.

And now that he’s going to take office, he’s talking about a lot of programs that would potentially increase the debt significantly. His infrastructure spending package, for example, and at this point, we don’t know how that package is going to come together, how large it is going to be, but that package and the large tax cuts that he has talked about, those would contribute to an increase in the debt. Some organizations have looked at his campaign proposals and suggested that he would add somewhere on the order of $5, $6, even $7 trillion to the debt over the next decade.

But Trump and his team have argued that things like infrastructure spending and tax cuts would spur a big jump in economic growth, and that would help keep budget deficits under control. Some economists are skeptical of this, but there’s a pretty good possibility that we’re going to have an opportunity to test that theory out. I think it’s too early to know how all that will play out. The reality of the situation is pretty simple. Sometime in 2017, Congress and the new president will have to engage in the debate about raising or suspending the debt ceiling. And despite the election outcome, the dynamics on Capitol Hill haven’t changed that much.

There remains a significant block of Republicans who have just refused to raise the debt ceiling, at least without having a corresponding amount of cuts in federal spending or something like that. And so that has meant in recent years that a debt ceiling bill has only been able to be passed, particularly in the House of Representatives, with the support of a mix of Republicans and Democrats. That’s a pretty fragile coalition. It has held together over the last several debt ceiling debates, and we’ll get a chance in 2017 to see whether it continues to do so.

Janet:

Mike Townsend, thank you very much for illuminating us today on this very complex and nuanced subject.

Mike:

Absolutely. It was great to be with you.

Janet:

Mike Townsend is vice president of legislative and regulatory affairs at Charles Schwab. You can read more of his commentary on the Insights & Ideas Policy Watch section of Schwab.com. That’s it for this installment. The Insights & Ideas podcast is brought to you by Charles Schwab. You can find us on iTunes or at insights.schwab.com. If you enjoyed this episode, please subscribe and write a review on iTunes. Thank you for listening.

Important disclosures:

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

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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