This post originally appeared on May 23, 2023.
Introduction:
For those of you who don’t follow the daily hyperventilating financial press, the big news during the last few weeks has been the potential debt default by the US government that will roil financial markets, make international trade uncertain, and cause a worldwide recession or worse. DKI has been tracking the issue for months, and we haven’t written about it because the entire subject is political theater. However, Treasury Secretary, Janet Yellen has declared the “x-date” could be as soon as June 1st. That’s the date the government runs out of money and “would” default, causing financial tragedy.
Over the weekend, House Majority Leader, Kevin McCarthy, met with the White House. Both sides declared they didn’t have enough common ground to arrive at a deal. Almost everything you’ve read in the press about the issue is complete nonsense (that means either lack of knowledge or lies) so let’s go through the details.
Background:
We’re going to give basic descriptions to make the issue more approachable. Congress approves spending and levels of taxation. When spending exceeds taxes, the government runs a deficit, requiring that the US borrow money. The Treasury Department along with the Federal Reserve issues debt to pay the difference. (Again – simplified version.) Add enough debt and currency creation, you end up with both inflation and rising interest payments that take up an increasing part of the government budget. Regular DKI readers are familiar with the conclusion here.
At some point, the government will need to cut spending. It will also need to create new dollars to pay the interest on prior debt. When that happens, there’s a debt death spiral, and the system proceeds to failure (default) or hyperinflation (stealth default). Once you’re printing currency to pay the interest expense, the system has almost certainly reached the point of no return.
Our current system has $31 trillion of on-balance sheet debt. There are also the off-balance sheet liabilities of future social security payments, Medicare, Medicaid, pension obligations, and other promises of benefits. These promises represent future payments which are not included in the official debt calculation. All of this adds up to about $250 trillion (a quarter of a quadrillion dollars) and is more than can be paid. We can get wound up over the current debt ceiling debate, but no matter what happens, a default of one sort or another is inevitable. There’s no level of taxation that will produce $250T.
The current fight is over the debt ceiling. Congress votes on a limit to how much debt the government is allowed to have outstanding. Every few years, excessive debt-funded spending forces Congress to vote to raise the debt ceiling. This has happened more than 100 times since the rule was put in place. Sometimes, the process proceeds smoothly. Other times, we have partial government shutdowns and threats to destroy the financial system and credibility of the US by defaulting.
Some will complain that the process is flawed. After all, how can we not fund the spending that was already approved? The system was designed specifically to create this problem. The debt ceiling exists to add friction to the process of piling up unlimited debt. Remember that any excess debt-funded spending we have now will need to be repaid by future generations. There is no “free lunch” here; but rather, an ability to live on credit until our debt becomes too large to manage. The current discussion/fight on spending levels and future debt levels is exactly why the debt ceiling exists.
We’re Not Going to Default:
Politicians on both sides of the aisle are threatening disaster. The reality is the US hit the debt ceiling months ago as the Government acknowledged. The Treasury Department has been using “extraordinary measures” to keep us under the limit. That means we’re still accruing bills, but delaying payment on some of them. In reality, the US is well-over the limit. It’s just abuse of accounting quirks that has kept us “below” the limit. Washington DC has had months to get a deal done, and instead, has decided to delay to the last minute while screaming about the coming catastrophe. Serious people trying to solve a problem don’t behave this way. Attention seeking sociopaths do. (Don’t worry – the sociopaths I’m writing about are the people in Congress you didn’t vote for.)
There are two reasons we think there won’t be a debt default. First, an actual default would cause a catastrophe and that’s bad for the political careers of the people making the decisions. The incentive for the characters involved is to do a deal and potentially keep their jobs, or fail and lose re-election bids.
More importantly, the narrative has been that once the US hits the x-date, we will have run out of money and will default. This is untrue. There would still be enough money coming in through taxes to pay interest on the debt. The government would then need to make choices to prioritize spending, and like any teenager, would need to live within its current $31 trillion dollar allowance. Congressional spending is authorized for a maximum amount and most legislation doesn’t require the government to spend everything authorized.
This means that talk about default is hyperventilating hysteria. We’re not facing a catastrophic debt default; but rather, a temporary partial government shut-down. There would be a point where it would become challenging to pay for things like social security. We expect the issue will be resolved well before then. In the unlikely event that it isn’t, you should expect every single politician in Washington who contributed to this mess to be replaced. Senior citizens vote in huge numbers.
The 14th Amendment is Misunderstood:
There has been talk from the White House that the 14th Amendment to the US Constitution which says that the validity of US debt “shall not be questioned” enables it to circumvent Congress and issue more debt. This is incorrect. Let’s take a quick civics lesson led by attorney and member of the DKI Board of Advisors, Phil Kessler. He and I agree there are three levels to the 14th Amendment issue.
Level 1 – What “Shall Not Be Questioned” Means:
You’ve probably read a lot of rhetoric about what the 14th Amendment really means. It simply means that the US can’t claim that its debt is legally invalid. A debtor can declare bankruptcy without claiming that the debt wasn’t somehow obtained lawfully and isn’t genuine. There is a major difference between telling someone their claim is invalid and saying “I’m running out of money and can’t repay it”. No one is suggesting that the US send a note to all Treasury bondholders informing them their claim is not valid. In the end, the US will pay the interest and principal on its debt even if it’s a bit late. No one is repudiating any debt. This is a financial issue, not a Constitutional one.
Level 2 – How to Avoid Default:
As explained above, even if the US goes past the “x-date” without a debt ceiling deal, the White House and Treasury Department can prioritize paying interest on the debt. That would avoid the threatened financial calamity and ensure that anyone claiming the 14th Amendment means we have to pay our debts (rather than just acknowledge they exist) has their argument satisfied. Again, the real “risk” here is a temporary partial government shutdown. The destruction of the financial system only happens if the White House and Janet Yellen make a conscious choice to pay debt service last instead of first. That would be an unwise decision to put it kindly and of questionable legality.
Level 3 – The White House Can’t Issue Debt:
There are some in the White House and in Congress who are advocating/threatening that because defaulting on the debt would, in their opinion, violate the 14th Amendment, the White House should ignore making a deal with Congress, and just issue more debt. As explained above, hitting the debt ceiling does not violate the 14th Amendment. However, the White House claiming that it has the “power of the purse” and issuing its own debt plainly violates the Constitution. This route would be a terrible idea. It would turn a blind eye to the constitutionally mandated separation of powers in a brazen violation of the rule of law. It would create uncertainty in the financial markets, and would be the subject of an extended trip through the Courts. Both Phil and I believe the Supreme Court wouldn’t rewrite the separation of powers in the Consitiution and create an Executive right to circumvent the debt ceiling.
McCarthy’s “Draconian Cuts” Are Not Cuts:
Democrats are attacking Kevin McCarthy and House Republicans for “draconian” spending cuts which they claim will create personal hardship for millions. At DKI, we specialize in translating misleading government rhetoric and statistics for normal people. Washington DC never cuts spending. Spending always grows. That’s true no matter which party is in control of which branch of the government. McCarthy’s spending “cuts” simply mean a reduction in the rate of spending growth.
Annual deficits are in the $1T – $2T range. Including off-balance sheet liabilities, the government is incurring annual expenses and liabilities of $6T – $8T above taxes. With interest rates no longer zero, that’s going to lead to so much interest expense that soon the government will need to print currency just to service the debt. What we need are actual spending cuts. McCarthy proposing a reduction in the rate of growth is neither draconian nor sufficient.
The press has regularly quoted Joe Biden saying there would be no cuts and no negotiation. This is typically followed by commentary that a default would be catastrophic. It’s difficult to take someone seriously who says no deal on an issue would be a catastrophe, and who also says that any negotiation is off the table. McCarthy responded by asking whether Biden thought that all government spending was necessary, or if he could acknowledge that there is some waste in the system.
The Democrats are entitled to think their spending plans are reasonable. However, as of this writing, McCarthy has a bill that’s passed the House which would increase the debt ceiling in exchange for reductions in future spending growth (not cuts). As of now, so far as we know, the Democrats only counter is to refuse to give ground on any point. Again, they’re entitled to think all spending is essential, but don’t have the votes to get anything done without Republican support. That means that deciding not to negotiate isn’t enough. This is assuming the goal is to arrive at a deal and not crash the system. (Biden and McCarthy have started to talk regularly complete with threats from both sides.)
Also, does anyone reading this think there isn’t any waste in the system? The government spends trillions of dollars a year. I guarantee you that if any of us had a list of spending plans and 48 hours in Washington DC, we could all find $100 billion of unnecessary excessive spending. Even that wouldn’t be enough to matter given the rate at which the US is accumulating debt.
In the end, neither side is serious. The is unfathomable and unconscionable, given the domestic and international stakes, the latter of which include the almost certain additional hit that the reliability of the US is taking in the eyes of the world. This is a concern if you want to maintain the dollar as the world’s reserve currency. Even if McCarthy got 100% of what he wants, the US is still going to run up trillions of incremental debt and liabilities every year. This eventually ends in catastrophe and default because both parties are guilty of massive overspending.
Work Requirements Are Not a Punishment:
Democrats are also angry that McCarthy’s plan includes a work requirement for people on welfare. They’re claiming it will harm children. The problem with these claims is the work requirement applies to people who are relatively young AND who don’t have children. Most of the country is fine with the idea of people working in exchange for their government check, or engaging in job training that will help them get off of welfare.
In the 1990s, President Clinton partnered with Speaker Gingrich on a successful bill that had similar goals. One of the ways welfare traps people is it discourages them from taking low-paid entry-level jobs. Those low-level work experiences become the first step for people to gain more responsibility and bigger future paychecks. That’s good for society and for the people who find meaning and more income in their work versus a welfare check.
Many still point to that legislation as an excellent example of bipartisan dealmaking. It reduced the demand on the taxpayer. It resulted in many people working instead of staying on welfare. It also raised President Clinton’s stature as someone who could make a good deal with his political “enemies”. We applaud President Clinton and Speaker Gingrich for their willingness to deal with each other in support of positive legislation. If the current occupants of those offices are unwilling to do the same, then there’s no reason to take their claims of coming disaster seriously.
Conclusion:
- Hitting the debt ceiling doesn’t trigger a 14th Amendment crisis and nothing gives the Executive branch the ability to approve, much less issue, additional debt.
- This “urgent” issue has been around for months. The parties in Washington chose to wait until the last minute to make a deal (or not).
- The “penalty” for failure isn’t a collapse of the financial system. It’s a temporary partial government shutdown. We’ve had those before and would survive another.
- Both sides have a strong incentive to make a deal, or face difficult re-election prospects.
- The government has $31T of official debt and around $250T of liabilities. Regardless of which side “wins” this negotiation, the government will continue to run annual multi-trillion-dollar deficits. None of this is sustainable. None of these people are even remotely close to dealing with the real issue. None of these people are serious.
- Unless the White House and Janet Yellen choose not to pay interest on the debt, there will be no default. There is likely to be substantial volatility. We remain well-hedged.
Feel free to reach out at IR@DeepKnowledgeInvesting.com with any questions.
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