Debt ceiling debacle risks a self-inflicted recession

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Gregory Daco

  • Treasury Secretary Janet Yellen has warned Congress that the US will reach its statutory debt limit on January 19. In her letter to House Speaker Kevin McCarthy, she asked Congress to either suspend or increase the debt ceiling.
  • Once Treasury hits the $31.4t debt limit, it will begin using “extraordinary measures” to prevent the US from defaulting on its obligations. These special accounting measures should provide Treasury with around $400b in additional borrowing capacity under the debt ceiling. Treasury Secretary Yellen estimates these measures should prevent the need to raise the debt ceiling until June, depending on individual and corporate income tax collections during the tax season.
  • Without a debt limit increase, suspension or removal, we believe Treasury would look to prioritize debt payments leading to delays in some other payments. Still, in doing so, Treasury would need to balance the federal budget by ensuring that government outlays are equal to government revenues. This would mean an instantaneous cut to GDP worth around 4.5%–5.0% leading to a self-inflicted recession and risking severe financial market dislocations.
  • Why a potential debt ceiling crisis? In trying to garner support for his election, House Speaker McCarthy provided conservative Republicans with a commitment to attach significant spending cuts to any increase or suspension in the debt limit. As such, while most policymakers would favor a clean raise in the debt ceiling, there is likely to be significant opposition to spending cuts by Democrats in the Senate. (A debt ceiling increase requires a majority in the House and 60 votes in the Senate.)
  • Alternative options? Several alternative options have previously been discussed:
    • These include Treasury minting a platinum coin, depositing it at the Fed and using the proceeds to meet its obligation, but this raises the obvious question of direct debt monetization.
    • Another option is to invoke the 14th Amendment, which states that “the validity of the public debt of the United States, authorized by law, … shall not be questioned,” thus questioning the constitutionality of the debt limit, but this has been rejected as an option by prior administrations.
    • Alternatively, some have discussed the possibility of a “discharge motion” that would circumvent the need for the approval of a committee chair as well as the Speaker to be introduced for a floor vote, thus allowing moderate House Republicans to join Democrats in raising the debt limit. However, this procedure would take well over a month and, as such, wouldn’t be a last-minute option.
  • Perhaps the most valuable (albeit extremely unlikely) approach Congress could take would be to eliminate the debt ceiling altogether. Contrary to popular belief, the statutory debt limit doesn’t serve much purpose. Whenever Congress passes legislation containing new federal spending and revenue measures, these imply a de facto increase or decrease in the debt. As such, the debt ceiling doesn’t impose any fiscal discipline on policymakers, and merely reflects prior legislation. Because the debt ceiling is often used as a political bargaining chip in a game of chicken to see which party would risk reaching the debt limit, the economy would be better off without it.   

The views expressed by the author are his own and not necessarily those of Ernst & Young LLP or other members of the global EY organization.

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