Debt ceiling showdown

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   By Guest Blogger Ryan Lewenza

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Here we go again. The US government has hit its debt ceiling limit, which is the legal limit of national debt that the government can accrue. Once this level is breached the US Congress needs to vote to increase the debt limit so as to avoid defaulting on the debt. Since 1960, the US Congress has voted to increase the limit 78 different times so this increase will make it lucky 79.

The issue is that with the Republicans taking back the House and a hard-right faction of the Republican Party – the House Freedom Caucus – gaining incredible control in the party (there’s roughly 30 of them which is meaningful given the Republicans narrow majority), they’re setting up for a fight and may use the debt ceiling as leverage to force the Democrats to agree to major spending cuts, something the Dems have been very reluctant to do. So, in the coming months we’re going to see a political version of Gunfight at the O.K. Corral, with big implications for the US economy and markets.

Today I’m going to review how the US got into this predicament, how I believe US politicians should deal with the out-of-control deficits and debt, and my take on how this may play out in the coming months.

The US Treasury officially breached its debt limit of $31.4 trillion last Thursday, forcing the US Treasury to start taking ‘extraordinary measures’. Essentially, the Treasury is just re-arranging deck chairs by delaying certain payments and buying time. This includes things like redeeming certain investments and suspending new investments into different government funds.

By implementing these measures the US government is able to kick the can down the road for a bit, which based on comments from the Treasury will get them till June. At this point, Congress has to act, which if the Republicans play hard ball like they did in 2011 and 2013, we could see some fireworks again. Cooler heads will ultimately prevail in the end but nothing surprises me these days coming out of Washington.

U.S. Government Debt at a Jaw-Dropping $31 Trillion

Source: Bloomberg, Turner Investments

But let’s back up and review how we got here.

There’s often a misconception that the debt is largely due to overspending (partially true) on government programs by the Democrats and that Republicans are much more fiscally prudent and deficit focused. That data does not support this.

Doing a simple analysis by adding up the deficits and contributions to the debt under the different presidents shows that it’s about a wash. More recently, under years of Republican presidents (Bush and Trump) the debt rose by $12.7 trillion and under Obama and Biden the debt rose $13 trillion.

Think about that for a minute. Since 2002, when Bush took over from Clinton, the US debt has exploded from $6 trillion to $36 trillion or a 6x increase. How did this happen?

The Republicans added to the deficits and debt through their aggressive tax cuts (Bush in 2003 and Trump in 2017), wars (one estimate has the cost of the Iraq and Afghanistan wars at $1.6 trillion) and increased spending, particularly on defense. Last year, for example, the US government spent $800 billion on defense, which is more than the next 9 largest countries combined spending on defense!

Tax cuts are often sold on the premise that they will ‘pay for themselves’, also known as ‘trickle down’ economics. But outside of a quick boost to the economy, this often doesn’t materialize and then the government is left with a lower tax base to fund all the spending.

But Democrats are no better. Biden announced a third Covid stimulus plan of $1.9 trillion (Trump already did two to the tune of $3 trillion) and Obama rolled out an $800 billion package to deal with the fallout from the financial crisis. This is on top of all the other spending and programs they rolled out. I recognize there were some huge disruptive events like the pandemic, which required a large government response, but it was way too much and this trend of higher government spending has been going on for decades.

The chart below calculates the percentage of US government spending as a percentage of the overall US economy and it has been steadily rising. There’s just too much government spending and this chart speaks to that.

US Government Spending as a % of GDP

Source: Trading Economics

We need to be honest. Both parties contributed to this mess and it’s going to require an ‘all hands on deck’ plan to deal with these deficits and surging debt levels. The Democrats don’t want to talk about entitlement reform (e.g. Social Security) and the Republicans refuse to consider tax cuts. Get over it already. If you want to really start dealing with the debt it’s going to require bipartisanship and compromise, rare traits these days in politics.

In my view, it’s going to take addressing all three of the pillars – cutting government spending, entitlement reform and raising taxes – to rein in the deficits and return to a surplus so the US can actually start paying off some of the debt.

Last year the US government spent $6.27 trillion so if they were to cut say 10% across the board that would represent $627 billion of cuts, which is less than half of what the US deficit was in 2022 ($1.37 trillion). Cutting spending will not be enough, which is why I believe the US needs to consider reasonable tax increases as well. Finally, both Social Security and Medicare will need to be reformed as boomers continue to age and these programs are only fully funded for so many years. This is why I believe all options need to be on the table and that the pain will have to be shared.

Back to the looming debt ceiling, as we saw from those depressing votes to elect Kevin McCarthy as Speak of the House, the Republicans have a very narrow majority (could get even narrower if Santos steps down) and given this the Freedom House Caucus is going to try to get their ‘pound of flesh’ and force the Dems to cut spending. While I don’t agree with their tactics I do agree with their current stance (many of them were fine when Trump was spending gobs of money) that addressing the spending and deficits needs to be a priority.

So we’re likely going to see some headlines and potentially some market volatility around the spring as we get closer to the date that the US Treasury runs out of cash. But like the other 78 times they will get a deal done even if in the 11th hour since the alternative (default) is just not an option.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.