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The Debt Ceiling Crisis of 2023: What We Know, What We Should Do

In March, we were all worried about the banking system in the US, and whether the failure of Silicon Valley Bank would spread far enough to threaten the entire US economy. We wrote then that allowing a few banks to fail would probably not crash the entire system, or bring down the stock market — and so far it looks like we were right.

This month, the key topic of conversation has been the political brinksmanship over the “debt ceiling”, and the potential impact that could have on the economy and markets. Here we will lay out what the problem is, what it might mean, and what we ought to do about it. Briefly: This appears to be a manufactured crisis, which could and probably will be resolved pretty easily, and the best approach for all of us is to remain invested in our long-term portfolios.

 

What’s Going On?

Prior to 1917, every time the Treasury wanted to issue some new bonds, the Congress had to pass new legislation to authorize that issuance. Recognizing, though, that expenditures related to World War I were likely to mean that the Treasury would need to create new bonds faster than they could be individually authorized, Congress gave the Treasury a blanket authorization: go ahead and sell whatever bonds are necessary, up to a limit of $15 billion. Further legislation over the 1930s and ‘40s made the limit more formal, marking different limits for different types of bonds, and raising the limit; in 1945, for example, the limit was raised to $300 billion. Over the next few decades, raising the debt ceiling was a simple and non-controversial matter — in part because it was recognized that refusing to do so would force the United States to default on its debts, which would have enormous impacts on the economy, the markets, and local and global politics. It wasn’t a risk that seemed worth taking.

But in 1995, then-Speaker of the House Newt Gingrich used it in his negotiations with President Clinton over the size and scope of the Federal budget, attempting to force spending cuts, ultimately resulting in the government shutdowns of 1995 and ’96. And again in 2011 and 2013, then-Speaker John Boehner used it during negotiations with President Obama, for the same purpose and to the same general effect: in 2011 the slim margin by which default was avoided caused credit agencies to downgrade US Treasury bonds, and in 2013 the showdown caused a government shutdown and another round of downgrades. During the Trump administration, the debt ceiling was again routinely raised.

And now, Speaker Kevin McCarthy is using the need to raise the debt ceiling as a tool in negotiations with President Biden, trying to push through cuts to Federal spending. A handful of public meetings have taken place already, and no doubt many non-public meetings are happening as well, but the apparent unwillingness of McCarthy and House Republicans to negotiate is concerning — and global ratings agencies are beginning to react negatively.

 

What’s Next for the Economy & Markets?

The results of a full formal default would be … well, very bad. If you want to see some of the scary predictions, here are a few from leading and reliable sources — NPR, Business Insider, NYT, Washington Post — but you have probably heard at least some of this already, and reading it may not be a great use of your time. While there are plenty of voices out there saying that default and disaster are inevitable, the general consensus among economists is that there will almost certainly be a last-minute deal to raise the ceiling.

If a deal does not come together, though, there are two different types of approach that the Biden administration could take to resolving the crisis. In the words of The Economist, “One is magical, the other messy, and neither is appealing.” The “magical”, or at least “creative”, solutions include: (a) creating a “trillion-dollar coin”, which the Treasury could mint and deposit in its account at the Federal Reserve; (b) invoking the 14th Amendment’s clause guaranteeing “the public debt of the United States”; and (c) issuing “premium bonds” with a very low face value but a very high official interest rate. While all of these are interesting ideas, none of them is actually likely to work, if only because all would be immediately challenged in the courts. On the other hand, “messy” solutions include various ways to “prioritize” the payments that the Treasury must make: technically, as long as payments on Treasury bonds are made, the US hasn’t defaulted on its debts but only “delayed paying” its other cash-flow obligations … but such an approach is probably only feasible for a few days, and would only technically avoid default.

However: Like most economists, and the majority of the investment industry, we believe that a deal is far more likely than default. And the news from Washington appears to be optimistic today.

 

What Do We Do Now?

So, given all of this, what are we planning and doing for our clients?

The probable outcomes of a full-scale default would be disastrous, according to all the analysts. But nobody knows which direction the disaster might lean — will it devastate US stocks most? Government bonds? How might it impact markets outside the US? Is there any investment opportunity that would not be at significant risk of crashing, if the debt ceiling crisis leads to default? As we saw in 2022, there are periods in which there are no places to hide from market turmoil; the structure of this event appears very similar. If so, there is probably no course of action we could recommend to every client that would protect their assets, and anything we might do would risk making a bad situation worse.

But, as we said, a deal is more likely than a default. And regardless of when a deal is reached, we can be certain that the next few months will bring us one thing: volatility. Some parts of the market will jump up, others down, but we can’t predict what will move in which direction beforehand. Fortunately, the well-diversified portfolios we construct for our clients are designed to weather the worst short-term market storms, and emerge positioned to take advantage of long-term opportunities. But that only works if we can maintain our discipline despite our temptations to make dramatic portfolio changes. We believe that the current market turmoil will die down, eventually, and ten years from now will be hard to discern in the long-term charts.

As investors, we can always find reasons to want to take our money out of the market or not invest it at all in the first place. But we are optimistic that investing your assets in a well-diversified portfolio will, over the long run, have the best chance of producing the results we all want. So let’s not make changes to your portfolio, unless something vital has changed in your financial situation. Our best tools so far have been diversification and calm discipline; let’s not give those up quite yet. But If you have questions about any of this, want to review your portfolio and Investment Policy Statement, or are interested in discussing a brand-new relationship as a client with Horizons, please let us know. We’re happy to help!