How a compromise on the debt ceiling could reward the U.S.

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As the U.S. debt-ceiling clock ticks down, let’s get one thing straight. No matter what you’ve read or heard, the United States government will not default on its debt.

Well, yes, it could. In theory. But the stakes are much too high for that. Which is why both Democratic and Republican leadership worked through the weekend to hammer out a compromise, which they now have to sell to their parties before the legislated debt limit is reached – before the end of this week, maybe a few days longer.

But even if the deal on the weekend between President Joe Biden and Republican House Speaker Kevin McCarthy fails to win support in both houses of Congress – which remains a very real possibility – it’s highly unlikely that the world’s most powerful economy is going to renege on its debt obligations. There are entirely reasonable ways for the U.S. government to continue making its payments.

Reasonable, that is, if you’re willing to trade a debt crisis for an economic crisis.

Here’s the bizarre situation, in brief.

The United States has a law, dating back more than 100 years, under which Congress approves the maximum amount of debt the government can incur. Every few years, the government reaches that limit, and Congress must approve a raising of the ceiling. Whenever Democrats control the White House and Republicans control the House of Representatives – as they do now – it has become habit for the Republicans to demand budget concessions before they agree to increase the ceiling. And to play a game of bargaining chicken that has, at times, pushed the issue to the 11th hour.

Which is where we are today. A crisis in the making, a last-minute deal, fingers crossed that law makers – particularly those on the far right of the Republican caucus – can accept a compromise.

Last week, some pretty important institutions warned the United States to smarten up.

On Friday, the International Monetary Fund scolded that “brinkmanship over the federal debt ceiling could create a further, entirely avoidable systemic risk to both the U.S. and the global economy, at a time when there are already visible strains.” It advised Congress to “immediately” raise or suspend the debt ceiling, and to come up with “a more permanent solution to this recurring standoff.”

While Congress has never been particularly responsive to advice from the IMF, the bond-rating agencies will certainly get its attention. Fitch placed the U.S.’s platinum-placed AAA debt rating on “rating watch negative” – a precursor to a dreaded downgrade. A senior official at Moody’s told the Reuters news service that his rating agency might do the same.

To be clear, neither the IMF nor the rating agencies predict an actual U.S. default. If the debt ceiling is reached, and not raised, the most likely scenario is that the government will make its required debt payments with incoming revenue (taxes). Whatever incoming revenue that is left over will pay for government programs, benefits to individuals (such as social security and medicare), and public employee wages. By the letter of the debt-ceiling law, borrowing wouldn’t be an option.

This is where the big problem comes in. It’s less about politics than simple mathematics.

The U.S. federal budget spending for 2023 is about 25 per cent higher than revenue. That implies that with the debt ceiling in force, Washington would have to cut its spending by 25 per cent. If it prioritizes debt payments, the cuts to all other spending will have to be even deeper than that.

That budget deficit is equivalent to 4.6 per cent of gross domestic product. If you remove that much from GDP, even for a short time, you are begging for economic trouble. In the current situation, with the economy already slowed by high interest rates, the math adds up to a recession pretty quickly.

And that’s before you even start considering the potential financial system instability – which would be global in scale – of having the U.S. government and its vital bond market dragged into such a predicament.

Which is all a compelling argument for the combatants on both sides to accept the Biden-McCarthy deal, or something close to it. In fact, this sort of compromise – in which the Democrats accept a cap on non-military discretionary spending, while the Republican relent on the much deeper spending cuts that they wanted – might actually turn this entire mess into a win for the economy.

Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, wrote in a recent report that it’s actually an opportune time for government spending restraint. Near-term austerity would slow the economy and ease inflation pressures in the process – taking some pressure off the U.S. Federal Reserve to raise interest rates further in its inflation fight.

“Right now, we’re in a period in which fiscal restraint could actually be painless for the economy as a whole,” he wrote. “Tightening fiscal policy would enable the Fed to take a less aggressive path on interest rates.”

“Such a rebalancing of restraint would actually be a less risky path, reducing the odds that strains associated with a record pace to rate hikes end up being an excessively severe hit to the economy, due to unanticipated spillovers into the financial system,” Mr. Shenfeld argued.

So, a compromise is the best path all around – as, indeed, compromises often are. Let’s hope that over the next few days, the feuding Republicans and Democrats can cut through the political and ideological fog enough to find that path.