Game of Chicken
Another year, another debt-ceiling crisis
In Greek Mythology, Sisyphus was the king of Ephyra. He had a reputation for cruelty and cunningness — As the legend goes, when death came to fetch him, Sisyphus chained up death itself so that no one died. But what made Sisyphus famous was the punishment dished out by Hades (the God of death) for trying to avoid death.
Sisyphus was condemned to roll up a heavy boulder to the top of a mountain for eternity. The maddening nature of the punishment was that when he was just near the top, the boulder would slip from his hands and then roll down, forcing him to start over again.
The U.S. Treasury Secretary Janet Yellen is in a similar position: every two years or so, the U.S. approaches the debt ceiling and the treasury has to scramble to make ends meet. After a lot of cajoling and political grandstanding, Congress approves raising the ceiling by just enough, ensuring that the treasury will go through the same issue just a year or so later.
The last debt limit raise was in Oct 2021 and the U.S. Govt. already hit the new limit of $31.4 trillion on Jan 2023. Since then, the Federal government has been unable to borrow more money and has resorted to extraordinary measures to continue running the govt. As highlighted by Yellen to Congress, the Govt. is set to run out of money as soon as June 1st [emphasis added]:
In my January 13 letter, I noted that it was unlikely that cash and extraordinary measures would be exhausted before early June. After reviewing recent federal tax receipts, our best estimate is that we will be unable to continue to satisfy all of the government's obligations by early June, and potentially as early as June 1, if Congress does not raise or suspend the debt limit before that time.
Without getting too much into the politics, the TL;DR version is that Democrats want the debt limit raised without any spending cuts whereas Republicans want deep spending cuts to Democrats’ priorities in the bill. This game of chicken of who will blink first before the U.S. defaults can have catastrophic consequences for the average citizen.
A recent model from RSM shows us how devastating it would be if the U.S. goes into an actual default, in which the government, out of money, stops paying its obligations.
It would be an unfettered economic catastrophe. Our model indicates that unemployment would surge above 12% in the first six months, the economy would contract by more than 10%, triggering a deep and lasting recession, and inflation would soar toward 11% over the next year.
A brief history of the debt-ceiling
Like any other entity, the government needs money to pay down its liabilities: Social Security, Medicaid, interest on the national debt, salaries, the cost of keeping the government functioning, and any visionary projects that are all financed by the national budget. But the government has very limited income streams – taxes, mainly, and this gives rise to the national debt.
The U.S. is a credit economy – in simple terms, it borrows from the future to pay for the present, with the expectation that future economic growth will reimburse the loan taken now. But without controls on borrowing, this can lead to reckless spending. The debt ceiling aka debt limit is the total amount of money the US Government is allowed to borrow – think about it like the credit limit available to a country.
Till 1917, every government expense was directly authorized by Congress, but the need to take quick financial decisions during World War I gave rise to the debt limit –bonds were issued in the aggregate, and it was fine as long as the issued amount was below the limit.
The debt ceiling is routinely modified and the irony of the current crisis is that the debt ceiling has been changed 102 times since World War II.
So, what’s different about this time?
Well, it’s hard to measure the risk of an incident, but one of the measures is to look at how much people are willing to pay to insure against the incident. In this case, 5-year US Credit Default Swaps are at their highest since the 2008 financial crisis, making this one of the most expensive times in history to insure against the possibility of a US Default.
While the implied probability of a U.S. default is only 4%, markets get easily spooked — When S&P downgraded the U.S.’s credit rating in July 2011 during the debt-ceiling crisis, the S&P 500 fell by 15% in just a month. The economic backdrop then was stronger than it is today – The Fed was stimulating markets with low rates at a time when investors were worried about deflation.
An actual default this year would make the Covid crisis look like a joy ride — with the Fed trying to fight off recession, tighten lending policies, and dampen inflation, now would be the worst time for the Govt. to go into default.
To figure out what might happen, we can study the past for some clues…