That 2011 feeling: A Q&A on the US debt ceiling impasse

Debt ceiling will almost certainly be raised, but the path will be bumpy

Democrats and Republicans are once again embroiled in a bitter fight over the debt ceiling, and last week, Treasury Secretary Yellen warned that the US government could run out of cash as soon as 1 June. How are developments likely to proceed in the weeks ahead?

How soon could the US government run out of money?

Potentially as soon as early June, but more likely late July.

Technically, the US already breached the administrative debt limit on 19 January; since then, the Treasury has relied on so-called ‘extraordinary measures’ and sizable cash buffers to avoid default and to enable the continued smooth functioning of government. With tax receipts coming in weaker than expected in recent months, Secretary Yellen warned that the government could run out of money as soon as 1 June. This is likely a cautious estimate, and as long as the government makes it to mid-June (a key tax payment deadline), the Treasury will likely have enough in reserve to keep it going until late July. Still, the risk the government runs out of cash sooner is likely to focus minds among members of Congress to strike a deal at a more accelerated timeframe.

How are negotiations progressing?

There are no negotiations at present, with Democrats and Republicans far apart on the issue.

Similar to the 2011 debt ceiling impasse, the government is divided along partisan lines, with Democrats controlling the presidency and the Senate, and Republicans controlling the House. All three branches of government need to pass any legislation that would raise the debt ceiling, meaning an agreement between the two parties must be struck.

At the time of writing, there is no formal negotiation taking place between Democrats and Republicans on a measure to raise the debt ceiling, but President Biden is due to meet Republican House Speaker McCarthy for talks on Tuesday. Democrats want a two-step process: 1. A ‘clean’ unconditional rise in the debt ceiling; 2. Negotiations on any potential deficit reduction measures. Republicans want any rise in the debt ceiling to be part of a deficit reduction package. The House already passed one Republican proposal, which would see dramatic cuts to many of President Biden’s flagship policies (including renewable energy subsidies and student loan debt write-offs). This is naturally a non-starter for Democrats. At present, the only signs of compromise are coming from centrist Democrat/Independent Senators Manchin and Sinema, who are calling for both sides to start negotiations on a solution.

What is the most likely end game solution to the impasse?

A bipartisan compromise that both raises the debt ceiling and imposes some modest spending caps.

Broadly, there are two most likely outcomes 1) a last minute deal in late May/early June that involves some caps on spending; 2) a suspension of the debt ceiling to allow more time for negotiation, to potentially as late as the end of the fiscal year on 30 September, when another showdown is due to take place over the federal government’s budget authorisation (this in itself could lead to a temporary government shutdown, which would be the first since late 2018-early 2019). While time is not on Congress’ side (there are only around 8 days when both the Senate and House are concurrently in session this month), precedent suggests that negotiations will in any case go right to the wire.

How could a default play out for the economy and markets?

A default – or even near-default – would have deeply negative implications for financial markets and amplify recessionary forces that are likely already at play.

A technical default – one that involves the government missing coupon payments and therefore triggering credit default swaps – is highly unlikely. Should the Treasury run out of cash, we expect it to prioritise bond coupon payments over other financial commitments, even if that means swingeing cuts to spending and a partial government shutdown. However, the longer this were to go on for, the negative impact on financial markets and on the economy would become increasingly non-linear. Roughly speaking, spending cuts to stay within the debt limit would amount to around $10bn per day; over two weeks, this would be around 0.5% of GDP. This is without considering the multiplier effects, the confidence effects, and the tightening of financial conditions (such as from sharp falls in equity markets) that would result. All of this would amplify the existing recessionary forces of high interest rates and tightening bank lending standards, and turn the mild recession we expect into a more severe recession.

One peculiar effect all of this would have is that bond yields would likely fall, as safe haven demand would likely offset higher risk premium effects. This happened during the 2011 debt ceiling impasse when S&P downgraded the US sovereign from AAA to AA+.

What incentive do Republicans have to come to a compromise?

Failure to raise the debt ceiling is likely to harm Republicans more than Democrats, based on the 2011 experience.

A cynic might argue that it could politically be in the interest of Republicans to allow a debt default to cause a deep recession, as this could damage President Biden’s chance at re-election in 2024. History would suggest otherwise: following the 2011 debt ceiling impasse, opinion polls suggested most voters pinned the blame on Republicans, with three quarters of voters disapproving of the way Republicans handled the crisis. Indeed, should the government begin delaying social security payments to avoid default, many Republican voters would also be harmed by this. We judge therefore that Republicans have a strong incentive to forge a compromise with Democrats. With that said, one difference with 2011 is that the Republican House majority is relatively slim, which could make it more difficult for House Speaker McCarthy to garner sufficient support for an agreement.