The Debt Ceiling: What History Tells Us

In the past, every time this problem reared its head, an agreement was finally reached in Congress and a default-related crisis was averted. However, this time around, some are worried about the consequences of the current deep political divisions in Congress.

What will another debt ceiling showdown mean for the economy and markets this time? We can look to an incident in recent history for guidance.

What is the debt ceiling?

America’s debt ceiling is a borrowing cap that Congress sets for the nation. It was enacted in 1917 as a way to give the Treasury more flexibility in borrowing. Prior to that, Congress had to authorize each piece of debt in separate legislation. Congress created the first aggregate debt limit that covered almost all government debt in 1939.

Since the end of World War II, Congress has raised the debt ceiling more than 100 times. But since then, the national debt has surged. With the large amount of debt, and with more polarized political parties in Congress, the topic of raising the debt ceiling has become a much more fraught political issue in recent years.

U.S. Federal Debt Has Increased Dramatically Since the Great Financial Crisis

Shaded areas indicate U.S. recessions.

Source: U.S. Department of the Treasury. Fiscal Service, Federal Debt: Total Public Debt [GFDEBTN], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GFDEBTN March 22, 2023.

Extraordinary measures

Once the debt ceiling is breached, the Treasury does not default on its debts immediately. Instead, the Treasury can use so-called “extraordinary measures” to continue to pay its bills until an agreement to lift the debt ceiling further is reached in Congress. Treasury Secretary Janet Yellen says the Treasury is using those measures now and that she anticipates that they could float the economy until June or early July, if Congress doesn’t reach a deal to raise the ceiling before then.

Other, more far-fetched suggested tactics have been dismissed, such as the U.S. Federal Reserve stepping in to buy defaulted Treasuries or the Treasury issuing a trillion-dollar coin to help pay the country’s bills.

Regardless, if Congress doesn’t raise the debt ceiling after the extraordinary measures have been exhausted, the Treasury will default. In this case, the term “default” does not mean that Treasuries go to zero; instead, it means that the Treasury will no longer pay interest payments on its debt.

What if there is a default? A flashback to 2011

What if there is no agreement in Congress and the country defaults on its debt? No one knows exactly how it would play out, but it would likely be quite undesirable for both the economy and markets. Let’s look at a real-life example: what happened in 2011, the last time we came to the brink.

There have been several debt-ceiling battles in Congress over the past decades, but the closest the U.S. government has come to actually defaulting was in 2011. Back then, “Tea Party” Republicans led the way in demanding that President Barack Obama negotiate over deficit reduction in exchange for an increase to the debt ceiling. Markets were in turmoil during the summer of 2011, the months leading up to a potential default, before an 11^th-hour agreement was finally reached in early August. The S&P 500^® fell -16 percent that summer and finished the year in the red, as shown on the following graph.

S&P 500® Performance June 30, 2011 to December 31, 2011

Source: FactSet

The S&P 500® Index is a product of S&P Dow Jones Indices, LLC and/or its affiliates (collectively, “S&P Dow Jones”) and has been licensed for use by Segal Marco Advisors. ©2023 S&P Dow Jones Indices, LLC a division of S&P Global Inc. and/or its affiliates. All rights reserved. Please see www.spdji.com for additional information about trademarks and limitations of liability.

Performance of Various Indices June 1 2011 to September 30 2011

Source: FactSet

The S&P 500® Index is a product of S&P Dow Jones Indices, LLC and/or its affiliates (collectively, “S&P Dow Jones”) and has been licensed for use by Segal Marco Advisors. ©2023 S&P Dow Jones Indices, LLC a division of S&P Global Inc. and/or its affiliates. All rights reserved. Please see www.spdji.com for additional information about trademarks and limitations of liability.

10-Year Treasury Yield January 1, 2011 to March 31, 2013

Source: FactSet

Default is still unlikely, but the situation is uncertain

The political conditions that produced 2011’s near-default situation are similar to the ones we have now. However, the current political environment is even more polarized than it was back then, and thus many are worried that the country could be in for a similarly high level of brinksmanship that may go down to the wire before the debt ceiling matter is resolved.

Even if a default is avoided, credit rating agencies are watching the situation to see if it will warrant downgrades of Treasury debt. Fitch, which still maintains a perfect credit rating for U.S. Treasury debt, is “more concerned this time around” according to its global head of sovereign ratings due to “repeated episodes” of debt ceiling brinksmanship which diminishes the U.S. dollar’s position as the global reserve currency and investors’ view of U.S. Treasuries as a risk-free asset.

An actual default on Treasury debt would have disastrous consequences and it is difficult to see Congress allowing it to happen. In early March, President Biden rolled out a deficit reduction proposal of over $2 trillion for the next 10 years in an effort to come to an agreement with Congress.

But even a close call will likely cause volatility for markets and may sting the economy in the short term. It is one more factor that could lead to continued volatility for markets in 2023.