The Real Problem Begins After Congress Raises the Debt Ceiling
The debt ceiling fight is getting down to the wire. In a letter to Congress on Monday, Treasury Secretary Janet Yellen said that without a debt ceiling increase, it was highly likely the government wouldn’t be able to meet all of its obligations by “early June, and potentially as early as June 1.”
Despite the drama, I still expect Congress to get a deal done. And that’s when the real problems begin.
As House Republicans and the Biden administration continue to negotiate with no compromise in sight, Moody’s Investors Service senior vice president and senior credit officer William Foster told CNN, “We absolutely don’t think there will be a scenario where we cross the X-date and interest payments will be missed.”
If we were less confident, we would change our outlook to negative.”
I agree with him. When this drama started in January, I called it a “fake debt ceiling fight,” and I said that nobody was seriously willing to contemplate default.
I could be wrong. Time will tell. But I’m still pretty confident that this is nothing but a dog and pony show with a bit of brinksmanship thrown in for dramatic effect. And when it’s all said and done, Congress will raise the debt ceiling.
But this doesn’t solve the problem. In fact, raising the debt ceiling will exacerbate it.
The fundamental problem isn’t that the US government can’t borrow enough money. The fundamental problem is the US government spends too much money.
In reality, raising the debt ceiling is enabling destructive behavior. It’s like handing a heroin addict a $100 bill.
The Biden administration has been spending at around a half a trillion dollar per month clip. In April, the US government blew through $426.34 billion. Thanks to all of that spending, coupled with declining tax receipts, the fiscal 2023 budget deficit already stands at just under $1 trillion.
There is no way the government can raise enough tax revenue to cover the spending without levying significant tax increases on the middle class, something nobody in DC is willing to do. It’s much easier to just keep borrowing money.
So, it has to raise the debt ceiling. It’s not just about a default. That’s just a talking point. The real issue is the federal government can’t maintain its current trajectory without borrowing more. And there is virtually nobody in Washington D.C. who is really willing to do what it takes to change that trajectory.
So, borrowing it is.
The problem is that isn’t sustainable either.
And that’s why I say the real trouble starts once Congress hikes the borrowing limit.
According to analysis by Goldman Sachs, the US Treasury may have to sell $700 billion in T-bills within six to eight weeks of a debt ceiling deal just to replenish cash reserves spent down while the government was up against the borrowing limit. On a net basis, the Treasury will likely have to sell more than $1 trillion in Treasuries this year.
Who is going to buy all of those bonds?
The market may be able to absorb all of that paper, but it will almost certainly cause interest rates to rise even more as the sale drains liquidity out of the market.
In effect, as the Treasury floods the market with new debt, bond prices will likely fall in order to create enough demand for all of those Treasuries. Bond yields are inversely correlated with bond prices, and as prices fall, interest rates rise.
A Bank of America note projects that the anticipated post-debt ceiling bond sale would have an impact equivalent to another 25 basis point Federal Reserve rate hike.
The liquidity crunch will spill over into the private bond market. The price of non-government debt instruments will have to fall as well in order to compete with Treasury bonds. That means the cost of borrowing will go up for everybody.
Rate hikes have already precipitated a financial crisis. The government and the Federal Reserve managed to paper over the problem with a bailout. But it’s only a matter of time before something else breaks in the economy. This bubble economy is built on easy money and debt. Take that away and the house of cards collapses.
The only other option is for the Federal Reserve to go back to quantitative easing.
In fact, even if it doesn’t happen immediately, QE is in the future. Much of this debt will ultimately have to be monetized. There is no other way for the market to absorb all of the debt the Treasury will have to issue to support the borrowing and spending.
In order to prop up the bond market and keep prices higher than they otherwise would be (and interest rates lower), the Fed will ultimately have to buy bonds to boost demand. It will buy those Treasuries with money created out of thin air.
In other words, you’re going to pay for all of this government spending through the inflation tax.
This is one of the reasons I keep saying the Fed can’t win the inflation fight.
The bottom line is that raising the debt ceiling doesn’t fix anything. It just kicks the can down the road. The only way to address the problem is for the government to significantly slash spending and bring it into line with tax receipts.
You can decide for yourself how likely that is.