The Risks and Rewards of Playing Chicken with The Debt Ceiling

Image: Freepik

The federal government's ability to borrow money to fund its spending is legally constrained by the debt ceiling. Congress established it in 1917 in order to grant greater control over the budget and avoid having to approve each and every loan that the government takes out. The debt ceiling only influences how the government pays back the money it has already spent, not how much it spends.

If the debt ceiling is not raised, the government will eventually run out of money to pay its bills, such as interest on the debt, Social Security benefits, military salaries, and Medicare payments. The government might thus be unable to fulfill its financial commitments to its creditors and other parties, which would result in a default. A default could have detrimental effects on the economy, including increased interest rates, lowered credit ratings, diminished investor confidence, and a potential recession.

Background

The debt ceiling is a yearly cap that Congress puts on the overall amount of government borrowing. The Second Liberty Bond Act, which gave the Treasury more leeway to finance the war effort, was passed by Congress in 1917, during the First World War. Without special Congressional permission, the act permitted the Treasury to issue bonds and other debt instruments as long as the overall debt did not reach a particular threshold. It was then referred to as the statutory debt limit or the debt ceiling.

Since then, Congress has increased or suspended the debt ceiling more than 100 times to account for the rising national debt. The debt ceiling permits the government to pay for expenditures that Congress has previously approved, rather than authorizing new spending. The public debt, which includes Treasury securities owned by investors like individuals, businesses, and foreign governments, and the debt held by government accounts, which includes Treasury securities held by federal trust funds like Social Security and Medicare, are the two parts of the federal debt.

The national debt and the budget deficit are connected but not the same as the debt ceiling. The entire amount of money owed by the federal government at any particular time is known as the national debt. The difference between what the federal government spends and what it takes in during a certain fiscal year is known as the budget deficit. The national debt increases when the government borrows money to make up a budget shortfall. When there is a budget surplus, the government can utilize the extra funds to reduce some of the debt.

In recent decades, the debt ceiling has been a cause of political contention and strife as both parties have attempted to push their budgetary objectives by using it as leverage. The economy and financial markets could suffer greatly if Congress doesn't increase or suspend the debt ceiling before the Treasury runs out of money. This would be the first time in history that the government has defaulted on its debt. Congress and the president typically come to an agreement to increase or suspend the debt ceiling before the deadline, sometimes after a period of brinkmanship and negotiation, to avoid this scenario.

Current situation

President Joe Biden and House Speaker Kevin McCarthy have been negotiating the debt ceiling and preventing a default for weeks. Political disagreements, ideological divergences, and conflicting goals have complicated the negotiations. Democrats insisted on maintaining Biden's infrastructure and green energy policies as well as raising taxes on the affluent and companies, while Republicans argued that any agreement must include budget reductions, tax reforms, and adjustments to social programs.

Both parties declared on Saturday, May 27, 2023, that they had made a preliminary agreement in principle to lift the debt ceiling by an amount sufficient to fulfill the country's borrowing requirements up until the November 2024 presidential election. Also, the agreement will increase military and veteran healthcare expenditures while capping spending on several discretionary domestic programs. It would not, however, include any tax increases or significant changes to the health and retirement systems that are ultimately increasing the debt.

The agreement still needs to be finalized and passed by both chambers of Congress before June 5. This might be difficult since some radical Republicans and Democratic progressives have warned to reject any settlement that falls short of their standards. Furthermore, the agreement makes no attempt to deal with the root causes of the debt issue or stop further debt ceiling confrontations.

Biden's leadership and his capacity to collaborate with Republicans on bicameral issues will be put to the test during the debt ceiling talks. Also, they are a clear reflection of the extreme divisiveness and broken political system in the United States. The result of the negotiations will have a huge impact on the American economy, credit rating, and international standing.

Risks

The US government is facing a looming deadline to raise its debt ceiling or risk defaulting on its obligations. The Treasury Department would run out of cash and borrowing capacity and be unable to make all of its bill payments on time if Congress does not take action to increase or suspend the debt ceiling by June 1.

The US and the world economy would suffer greatly and permanently if the US government went into default. Here are some of the potential risks:

• A spike in interest rates: The US Treasury market is the world's biggest and most liquid bond market, and Treasury securities are regarded as the most secure and dependable type of debt. In the event of a default, this reputation would be damaged and lenders would demand higher interest rates. This would raise borrowing costs for the government as well as for companies and individuals who use Treasury rates as a benchmark for other loans. The value of current bonds would decline with higher interest rates, costing investors money.
• A disruption of financial markets: Financial markets would experience a surge of uncertainty and volatility in the event of a default as investors rushed to alter their portfolios and mitigate their risks. This can cause investors to flee riskier assets like equities and corporate bonds in favor of safe havens like gold and foreign currencies. A default might also result in the US government's credit rating being downgraded, which might affect other debtors who are dependent on the creditworthiness of the US. A default might also impair the operation of important financial institutions and markets that use Treasury securities as security or as a means of exchange.
• A contraction of economic activity: A default would also hurt the real economy by lowering consumer and company confidence, reducing spending and investment, and raising unemployment. A default might hinder the government's capacity to deliver crucial services and benefits like Social Security payouts, Medicare payments, military pay, and tax refunds. Some projections state that a default would result in a recession that would lower US GDP by 6% and raise unemployment by 9%.
• A loss of global leadership: Additionally, a default would diminish the US's position as a world power and a reliable source of stability for the global economy. Due to a lack of political will and financial management skills, a default would damage the US's reputation and influence in world affairs. Also, a default may lessen the US dollar's position as the world's reserve currency, which favors the US in commerce and finance. While friends and partners rely on the US for security and economic support, a default may also destroy confidence and cooperation among them.

Rewards

Raising or suspending the debt ceiling, however, requires collaboration between the White House and Congress, which may have various agendas and objectives for the nation's budget. Sometimes, one party will use the debt ceiling as a weapon to pressure the other party into making concessions or adopting its favored policies, leading to a game of chicken in which both sides threaten to allow the country to default if their demands are not satisfied.

This game of chicken can have both benefits and drawbacks for both parties, depending on how they play it and how the public perceives it. Here are some possible rewards and risks for each party:

Democrats: Considering that the Democrats presently hold sway over the White House, both chambers of Congress, and the executive branch, they bear a greater burden for raising or suspending the debt ceiling and preventing a default. Additionally, they seek to raise taxes on corporations and the rich in order to support their ambitious agenda of spending on social programs, infrastructure improvements, and other issues like climate change.

Some possible rewards for playing chicken with the debt ceiling are:

• They might exert pressure on Republicans to agree with their spending plans or at the very least refrain from obstructing them by threatening default.
• They might make use of the debt ceiling to inform the public about the distinction between borrowing and spending as well as how their policies will strengthen the economy and lessen inequality.
• They may utilize the debt ceiling to galvanize their support base and turn out voters in time for the upcoming midterm elections.

Some possible drawbacks of playing chicken with the debt ceiling are:

• They could be held responsible for any unfavorable effects of a default or a close call, such as increased interest rates, decreased credit ratings, market turbulence, and decreased faith in the government.
• They might annoy moderate voters by portraying them as careless or reckless with the nation's money.
• They can encounter opposition from other members of their own party who don't share their goals for expenditure or strategy.

Republicans: Despite being in the minority in both houses of Congress, the Republicans still have some sway over the debt ceiling debate because they have the ability to filibuster any legislation in the Senate that would raise or suspend it. They also have differing ideas on the nation's fiscal strategy, favoring lower taxes, a smaller, less intrusive government, and less regulation.

Some possible rewards for playing chicken with the debt ceiling are:

• The fear of default might be used to pressure Democrats into reducing their spending commitments or accepting expenditure cutbacks or other reforms.
• They might use the debt ceiling as an opportunity to attack Democrats for misusing, wasting, and being socialist with tax dollars.
• They may utilize the debt ceiling to galvanize their support base and turn out voters in time for the upcoming midterm elections.

Some possible drawbacks of playing chicken with the debt ceiling are:

• They might be perceived as politicized, obstructionist, and unpatriotic for endangering the nation's security and creditworthiness.
• If they are seen as hypocritical or inconsistent for opposing debt rises during Democratic regimes but supporting them under Republican ones, they risk losing their credibility as fiscal conservatives.
• They might encounter opposition from members of their own party who might favor a less authoritarian or cooperative style of rule.

Conclusion

In conclusion, both parties may want to avoid playing chicken with the debt ceiling because it could have both favorable and unfavorable consequences for their political futures. The outcome could be influenced by how well they convey their ideas, how they conduct discussions and compromises, and how they handle criticism and public opinion. We have maintained that playing chicken with the debt ceiling is a risky and careless game that imperils the country's creditworthiness, standing, and stability.

To avoid such a catastrophic outcome, we have proposed some possible solutions that could break the impasse and prevent a default. These include:

• Removing the debt ceiling entirely because it has no real use and merely leads to unneeded angst and brinksmanship.
• Implementing a rule-based strategy that automatically changes the debt cap to reflect the objectives of fiscal policy and the state of the economy.
• Giving the executive branch the power to increase the debt ceiling, subject to congressional approval or override.
• The Treasury is given permission to issue debt above the cap by using the 14th Amendment, which provides that the legitimacy of the public debt cannot be contested.
• Creating additional borrowing capacity by issuing a platinum coin with a face value of at least $1 trillion and depositing it with the Federal Reserve.

Any of these alternatives, in our opinion, would be preferable to the possibility of a default, which may have disastrous and long-lasting implications on the economies of the United States and the rest of the globe. We implore the President and Congress to take prompt, responsible action to increase the debt ceiling before it's too late.