Because the United States has more bills to pay than the amount of revenues it takes in, the Treasury must borrow money (issue debt in the form of Treasury bonds) in order to make ends meet. Congress gives the Treasury an “allowance” in the form of a debt limit. If it needs more money, the Treasury must ask congress for permission to issue more debt.
In January of this year, the United States Treasury reached its $31.4 trillion debt limit. Therefore, Treasury Secretary Janet Yellen asked Congress to authorize an increase its borrowing capability so it could continue to pay the existing obligations of the United States. She said that if authorization was not given, the Government would essentially run out of money by June 1st. So far, The House of Representatives has refused to do so. To emphasize their stance, they narrowly passed a debt ceiling bill in April which would only authorize an increase in borrowing if spending cuts spelled out in their bill was made. The White House and Congress are negotiating in the hopes of coming up with a compromise deal by June 1st to raise the debt limit and avoid a serious financial crisis.
Why do we have a debt limit?
Prior to 1917, Congress had to pass a new law every time the Treasury Department issued new debt which took time to pass. When the United States entered World War I the Government needed to borrow a lot of money quickly to fund the war effort. To simplify the process, Congress enacted a new system where Congress authorized the Treasury to borrow a certain amount of money to meet the Country’s existing legal obligations. If the Treasury needed to borrow more money than the authorized limit, it would go to Congress and request permission to raise the debt limit. Ever since this new system was instituted, raising the debt limit has been more of a formality. During the 20th century the debt ceiling has been raised at least 90 times and has never been reduced. From 2001 to 2016 alone, the debt ceiling was raised 14 times.
What will happen if we default on national debt?
The reason why raising the debt limit has been traditionally a formality is because the consequences for not doing so would be catastrophic to the United States. If the U.S. defaulted on its existing debt obligations the Treasury would be unable to pay its bills including the interest and principal on Government bonds, Social Security & Medicare payments, and Military Salaries. In addition, defaulting on the Nation’s debt would cause a dramatic destabilization of the U.S. dollar and global financial Markets. The U.S Dept. of Treasury states: “Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations – an unprecedented event in American history. That would precipitate another financial crisis and threaten the jobs and savings of everyday Americans – putting the United States right back in a deep economic hole, just as the country is recovering from the recent recession”.
What is causing the current crisis?
Since the end of World War II until 1982 the size of the U.S. national debt averaged $3 trillion. Over the next 20 years it tripled to about $10 trillion. From 2000 to 2010 our debt increased even more dramatically to $18.4 Trillion. In 2011, the issue of raising the debt limit became a highly political and partisan affair. The Republican Party, uneasy about the size of the U.S. debt, delayed authorizing the debt limit and wanted to impose deep spending cuts and caps on the growth of federal spending. Eventually a deal was reached but it resulted in Standard and Poor’s downgrading the U.S. debt instrument rating for the first time in history. Ever since the debt crisis of 2011, authorization to increase the debt limit has been difficult and costly to the Nation because the process has become so overly politicized. Ironically, the debt limit crisis is one that the Executive and Legislative branch has created due to its severely dysfunctional budget approval process. The dysfunction is made even worse because of the highly partisan nature of our politics today.
How will it impact you?
In 2011 a deal was made just two days before the U.S. would have run out of money. The S&P 500 reacted to the news by falling 17% in two weeks. The same outcome or worse could occur this time around if a deal to increase the debt limit is not reached. Both the White House and Congress remain optimistic that a deal will be made and business will go on as usual. However, if there is no resolution to the crisis by June 1st, you can expect to see Market instability. The extent of Market instability will depend on how long the fight to increase the debt limit goes on. If the negotiations drag on and there is no resolution in sight, the chances of bankruptcies, a recession, and downgrading of U.S. Treasuries increase exponentially. The loss of global faith in the U.S. financial system will have far reaching consequences.
As far as you are concerned, be prepared for your long-term investment portfolio to potentially decline temporarily until the debt limit crisis has passed. We are investing for the long haul so any short-term adverse impact will not be material in the long run. Money required for today’s lifestyle needs should be invested safely in cash, CD’s, or individual bonds. As I always emphasize, money you need today should not be invested in the stock market.
The bigger concern would be a potential recession and a loss of jobs that could result if a resolution is not reached quickly. Therefore, be mindful of your emergency funds and make sure you have enough cash on hand to carry you through if you are faced with a short-term job loss.
Do not hesitate to reach out and contact me should you have any concerns about your long-term investment portfolio or current cash needs. Hopefully this political crisis will pass and we will move on to the next one!
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