The basic problem is that Congress loves spending and tax cuts, but doesn’t like debt. This leads to conflicting legislation: spending and tax bills that are incompatible with the debt limits set therein. This is not a question between Democrats and Republicans. Fiscally liberal Democrats can be re-elected without worrying about debt, and fiscally conservative Republicans will never lose an election if they oppose debt. It is the centrists in both parties who need votes from both fiscal liberals and conservatives. These are people who want more money from government and people who care about preserving the value of the money they already have. Moderate and conservative Democrats don’t want to be seen as ruthless financiers who force debt increases without bipartisan support, and moderate and liberal Republicans don’t want to be blamed for government shutdowns and market instability.
The usual assumption is that the middle will hold. The cap (currently about $31.4 trillion, leaving $300 billion of room for borrowing) will eventually be raised or another workaround found, but fiscal conservatives will make some concessions to limit spending reduce or tighten budgetary rules. However, the fights over the debt ceiling so far have taken place in good economic times with rising share prices and low inflation. Republicans, emboldened by electoral success to criticize Democrat spending, may feel they have a winning hand in forcing a rollback of the Biden administration’s expensive policies — by getting credit for easing inflation and protect US credit while showing the Democrats are ineffective.
I’m not a political analyst, so I can’t comment further on that. My topic is the likely market reaction when it comes to a bruise fight. Will the possibility of a default send the US dollar and the bond market into a meltdown like the UK almost did (and could still do)? Or will increased fiscal discipline in the US stabilize the markets?
One clue is that from mid-January 2023 to mid-April, Treasury bill rates are up to 0.5% higher than would be expected given earlier and later maturities. In other words, investors seem to be avoiding these bills. This is the likely period for a debt ceiling fight, although there are other possible reasons for the hump in the yield curve. At face value, this suggests investors are bracing for a significant possibility of major disruption, but not lasting damage. We will learn more about this when the election results are known in November.
Any fight over the debt ceiling, or even talk of it, will push up short-term Treasury interest rates and push up other dollar-denominated short-term interest rates as the dollar depreciates. It will stoke credit fears in the economy. It could fuel inflation by encouraging people to spend dollars instead of holding them and making foreign goods more expensive. It could slow down the economy by stoking fear and depressing stock prices.
The worst outcomes are a loss for the fiscal conservatives, weakening their future power, or a dysfunctional arrangement that only complicates things, guaranteeing greater future struggles and continued instability. This could lead to permanently higher government borrowing costs, lower confidence in the dollar and US credit, and rising debt with weakening controls. This could put the US on a path that Britain might have narrowly avoided.
The best outcome, at least for bond markets, would be agreement on a rational budgetary process with fiscal controls that allow Congress to choose and manage the level of debt and only allow spending and tax laws consistent with the chosen level of debt indebtedness match. The market is less concerned with the level of debt and more concerned with whether it is controlled and, if so, could be reduced. If the US is willing to service its debt, no one doubts that it can. Of course, a perfect solution is unlikely.
The stakes will be much higher in 2023 than in previous debt ceiling battles. Debts and deficits are much larger. While the 2022 budget deficit was half the size of 2021, it was equivalent to the largest non-Covid deficit in history, the 2009 financial crisis year. It also projected future deficits and debt, not to mention the unfunded budget deficit gap (primarily Medicare ), are much higher than conventional notions of fiscal prudence would allow. At the very least, the economy is arguably in recession, stocks are down, and inflation is high. If the situation is the same or worse in early 2023, we could be on the verge of an economic crisis even without a fight in Congress.
Crises tend to bring out the best and the worst in people. It could provide the energy for long-needed reforms or the excuse for damaging brinksmanship. I’m an optimist because I think the economy will likely get better on its own, the mid-term results will be mixed enough to deter great stance on either side, and Congress will choose sanity over mutually assured destruction. I’m an optimist because I prefer to be happy to afraid, not because I have strong reasons for hope.
More from Bloomberg Opinion:
• Debt crisis on Republican agenda for 2023: Matthew Yglesias
• Another absurd fight for the debt ceiling? No thanks: Jonathan Bernstein
• Biden has hurt the economy, not helped: Allison Schrager
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of The Poker Face of Wall Street. He may be involved in the areas he writes about.
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