The US Debt Ceiling: The Next Financial Crisis

It seems like we just bounce from crisis to crisis these days. Now that the Greek "can" has been successfully kicked down the road, all eyes will point to the next potential crisis: the raising of the U.S. debt ceiling.

Treasury Building
Treasury Building

The technical default date for the U.S. Treasury is currently estimated at August 2. This is the date on which the Treasury must use its daily cash flow, rather than its borrowing capacity, to satisfy its many daily obligations.

President Obama, in today's press conference, said that August 2 will mark the day that "we run out of tools" to deal with the debt-ceiling problem. Is he simply fear-mongering as many Republicans (read: Michele Bachmann) have suggested?

It is true that the government could still meet its debt service obligations after August 2. The government would simply have to eliminate some of its other obligations, such as Social Security checks, unemployment insurance, military salaries, etc. However disastrous this would be for individual families, it might pale in comparisons to the fallout resulting from the capital markets reaction.

As we approach the August 2 deadline, prospective investors in U.S. Treasury securities (most notably, foreign central banks) might be inclined to demand a higher yield to compensate for the increased risk of "default." Can you think of anything more counterproductive? The federal government is risking the only thing that has kept us out of disaster thus far—our low funding costs—as we run up ever-increasing deficits.

A Bernstein Research piece published this morning stated, "Each 0.1% increase in interest rates above CBO projections would increase the deficit another $130 billion over the next decade, CBO estimates, so nearing or breaching the debt ceiling could have just the opposite impact that policymakers are aiming for." I wonder what a 4% or 5% increase in interest rates would do to our deficits.

Quoting the same Bernstein Research piece, "We are upgrading the chances from 35% to 40% that the debt ceiling is not raised until after the technical "default date" and dangerously close to August 15, when sizable interest payments on Treasury debt come due."

More and more analysts are saying the same thing—our politicians lack the ability to compromise on this issue. Perhaps the last-minute passing of the Greek austerity package has emboldened U.S. policymakers to increase their brinkmanship and take this issue right down to the wire. Whatever the reason, failure to raise the debt ceiling could be a very dangerous thing for the U.S. and global economies. This is simply a game of chicken we cannot afford to play.

This environment is very difficult for investors in bonds and stocks alike. There have been numerous potential "black swan" events over the past few years. Equities swoon in anticipation of these events, and they rally when a short-term resolution is reached (the can is kicked down the road). But it's possible that policymakers may misplay one of these challenges and cause some severe consequences.

In the severity spectrum for black swan events, a default by the US.. Treasury would rank very close to a 10 on a badness scale of 1 to 10. We would suggest that Congress not mess with the current lifeblood of our existence, which is our seemingly endless ability to tap the capital markets in a very cheap way. We should thank our lucky stars that we are able to fund our profligate spending so cheaply, and we should not tempt the capital markets gods.

The increased willingness to push the envelope on the debt ceiling is not an encouraging development. In our opinion, Congress must address the debt ceiling NOW, or markets might not be so forgiving in the days leading up to August 2. And shortly after raising the debt ceiling, the government must also address the issue of long-term structural deficits as soon as possible.

As much as we have been blessed by cheap funding costs over the years, we simply cannot expect this to continue forever. Eventually, our drunken-sailor spending is going to catch up with us. The day may be closer than many in Congress believe and the consequences more dire than political repercussion.