Is The Debt Ceiling A Real Risk For The Markets?

With a new Congress and a new Speaker of the House of Representatives, investors are concerned about the effects politics will have on the economy and markets in the coming year. In particular, concerns about the debt ceiling are growing. But is this a real risk? Let’s take a closer look.

An extremely divided government

We now have a narrowly Republican House of Representatives, a narrowly Democratic Senate and a Democratic White House. This is an extreme form of divided government. Not only do different parties each control a house of Congress, but the margins of control are narrow enough that differences within parties can affect Congress’s ability to get things done. Rarely have we seen a government this divided or one that will find it so difficult to achieve anything significant.

We saw this in the last Congress in the Senate, where the overwhelming majority of Democrats meant that one senator could torpedo any policy he didn’t like. With both Manchin and Sinema under fire from the White House, policy initiatives were regularly limited to what they would accept. We’re seeing it now in the Republican House, and the results will very likely be the same. As a result, for anything to even pass, it has to have the support of almost everyone, meaning that the possibility of legislation that would make any significant changes is dead for the next two years. What you see is what you get for a federal policy.

Overall, this is a good thing for the markets. Markets like certainty. In many ways, policies are unlikely to change much. For things that don’t need to change, stable is good – and most things don’t really need to change. There is a positive.

Risk assessment

However, some things have to change, and this is where the concern grows. The federal debt ceiling, the legal limit on how much the federal government can borrow, is regularly breached as the country borrows more, and is raised just as regularly. However, this increase requires action and approval by Congress. That’s the one thing that has to happen this year that, according to political divisiveness, may not happen. This is where the main economic and market risks of politics come from.

Why is it necessary to increase the limit? The first reason is that Congress has already authorized the spending. It makes no sense to say we will spend the money but not do what is necessary to spend it. Second, and more powerfully, not spending money has immediate consequences: on people’s jobs and livelihoods, on national defense, on social security payments, and ultimately on the financial system itself. US government debt is the ultimate low-risk asset. And if it is not paid? Then the whole financial system could shake. If the US government decides not to fulfill its commitment, it will shake the economy and the markets. So if that were to happen, there would be real risks and we should monitor them. But will it happen? Probably not.

Is there a crisis?

While the risks are real, we’ve seen this movie before. Republicans regularly fight against raising the debt ceiling and occasionally succeed in shutting down the government. We’ve seen iterations of this battle in 1995, 2011, 2013, and 2021. In any case, we finally saw a resolution that brought things back together, despite fears that this will be the time when the system finally collapses. Even if we do get a debt ceiling shutdown this year, history suggests it will be resolved before it becomes a real crisis.

Of course, past performance is no guarantee, as they say, so we can’t count on that. However, if Congress fails to act, there are still measures that can be taken. A trillion dollar coin is one way and there are others. Nobody wants to do that, but the lesson of the Great Financial Crisis and the pandemic is that when necessary, government can and will act to avert disaster and worry about cleaning up the mess later. The worst case is always possible, but it almost never happens, as long as the will and tools are available to avert it. And they are.

A solvable problem

And this is how I look at the economic and market risks of the current political dysfunction. The risks are real, but they are not new and have always been limited historically. If Congress goes off the rails, more action can be taken. In short, as long as we follow the cliff—and we do—we won’t end up walking off it. By the way, when we focus on the risks, we must realize that there are also some positive aspects that will manifest themselves when we avert a disaster.

This debt ceiling problem is real, but not new and solvable. Watch it, but don’t worry about it.


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