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Debt Limit Brinkmanship Threatens Markets

By Shai Akabas, Ben Ritz, Mark White

Friday, July 10, 2015

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Investors took the “unprecedented” step of avoiding certain Treasury securities during the standoff over the debt limit in 2013, according to a new report from the Government Accountability Office (GAO) that provides insight into market behavior and economic risks related to delays in extending the nation’s borrowing authority. Specifically, securities that matured around the dates when the Treasury Department projected that it would exhaust extraordinary measures were subject to “both a dramatic increase in rates and a decline in liquidity in the secondary market where securities are traded among investors.”

Some background: The debt limit was most recently suspended last year and then reinstated on March 16 at $18.1 trillion (to reflect the total amount that had been borrowed by the federal government at that time). With no additional borrowing authority, the Treasury Department once again employed extraordinary measures, which allow the government to temporarily continue making all payments in full and on time while operating at the debt limit. While substantial uncertainty remains, the Bipartisan Policy Center (BPC) continues to project that extraordinary measures and cash-on-hand will most likely allow Treasury to meet all of its financial obligations until sometime in November or December of this year. BPC terms the last day upon which Treasury is able to do so the “X Date.”

Congress has been down this road many times lately, voting to either suspend or increase the debt limit a total of seven times since 2010. On several of those occasions, including the 2013 case examined by GAO, policymakers waited until the last possible moment, with extraordinary measures on the brink of exhaustion. The report finds that market confidence was shaken in the lead-up to the X Date and highlights several troubling—and highly uncertain—effects that materialized in 2013 and could do so again in future debt limit impasses, regardless of whether the government actually defaults on a payment:

  • Market transactions were impeded. GAO reports that major financial institutions stopped accepting Treasury securities maturing around the X Date as collateral in short-term transactions. Treasury auctions for these securities also saw tepid demand. This suggests a considerable lack of trust in an asset that is normally the foundation of the financial sector. These concerns created illiquidity in the markets and substantially raised the cost of short-term borrowing.
  • As the X Date drew closer with no action by policymakers, the impacts grew. GAO’s report suggests that a measurable acceleration in interest rates and market volatility occurred as the X Date neared. For example, GAO found that the increase in yields for targeted securities in secondary markets rose from 1 basis point in mid-September of 2013 to over 50 basis points just prior to the resolution of the standoff in October.
  • Treasury’s operations were constrained. A requirement exists that upon reinstatement of the debt limit, Treasury match the amount of cash on hand from when the limit was suspended. This necessitated sharp reductions to the amount of Treasury bills outstanding (thereby lowering its cash balance), which disturbed the Department’s ability to conduct normal market operations and also disrupted the market transacting in those securities.
  • The Treasury’s cash balance was reduced to an unnecessarily risky level. In the run-up to the X date, Treasury’s diminished cash balance contradicted the recent recommendation of the Treasury Borrowing Advisory Committee. Its determination was that Treasury should maintain a more substantial cash balance in order to provide a cushion against an unexpected disruption in the financial markets that obstructs the ability to borrow for a period of time. The Committee found that dropping below such a level incurs unnecessary risk.
  • Approaching the debt limit increased credit risk and imposed additional borrowing costs for the U.S. taxpayer. The mere suggestion that the federal government might miss a payment caused Standard and Poor’s to downgrade the rating on U.S. Treasury bonds, from AAA to AA+, after the debt limit standoff of 2011. GAO estimates that the 2013 impasse cost the federal government somewhere between $38 million and $70 million in added interest payments to service the debt.1

The consequences cited above are both tangible and harmful, but some market participants whom GAO interviewed thought that the risks could be even more severe in the future because of financial regulatory changes. Additionally, 2013 was a volatile moment for the global economy, so investors had few other safe havens, but in calmer times, the Treasury market could face much harsher fluctuations.

Important to note is that all of these consequences are those faced in advance of the X Date. If Treasury actually missed (or delayed) a payment, industry groups feared significant risk of damage to financial markets that could directly impact average investors. More broadly, passing the X Date with no action by policymakers could have widespread economic impacts that BPC has previously discussed.

Another section of GAO’s report focuses on the fact that the debt limit doesn’t actually control agencies’ ability to incur obligations or prevent gaps between revenues and outlays (spending). Rather, the limit simply caps the Treasury’s ability to pay the debts incurred as a result of spending and tax policy that Congress and the president have already authorized.

GAO highlights this contradiction and outlines three potential reforms for the debt limit. First, Congress could include debt limit increases with its annual budget resolution and subsequent emergency spending bills that would cover the borrowing necessary to execute the specific legislation. Second, Congress could implement something akin to the Budget Control Act’s “Motion to Disapprove,” whereby the president is authorized to raise the debt limit unless overridden by a veto-proof majority in Congress. Finally, Congress could fully delegate authority in this area and give the executive the power to borrow “such sums as are necessary” to fund laws enacted by Congress and the president (i.e., to cover the debt incurred via cumulative legislated spending and tax policy).

GAO’s report provides a valuable look behind the curtain at what transpired during the 2013 debt limit impasse and offers constructive suggestions for alternatives that policymakers might consider. The documented risks are serious in nature. Our leaders should carefully consider their actions (or lack thereof) on this issue and be cognizant of the growing risks as time passes.

Kenneth Megan and Jordan Berne contributed to this post.

1 This estimated cost is through the end of Fiscal Year 2014. A 10-year estimate of the additional borrowing costs would likely be significantly higher.