Prior to World War I, Congress would authorize specific loans and allow the Treasury to issue specific debts to pay for specific funding. As the federal government grew, this administrative burden to micromanage all the debts and liabilities of the government became untenable. Thus, that burden was outsourced to the Treasury to issue the debt with oversight by Congress. The Public Debts Act was formally created in 1939 to eliminate separate limits on different types of debt, making the United States’ debt one lump sum. Over the past 80 or so years, the debt ceiling has been raised 77 times, usually without consequence. To prevent Congress from issuing debt and not paying it, the Gephardt rule passed in 1979 and was repealed in 1995, paving the way for reoccurring debt crises and government shutdowns.
The U.S. Treasury collects the government’s tax revenues (the IRS is a subdivision), distributes the budget, and issues the debt of the United States. When there is a debt ceiling crisis, the U.S. Treasury is at the center of it. If a default were to occur, the Treasury could not issue additional debt (print more money) and would also be unable to distribute the budget and pay for ongoing liabilities like Social Security or military spending.
In January of 2023, the U.S. hit the debt ceiling, and since that time, the Treasury Department has taken “Extraordinary Measures” to keep the checks from bouncing. These measures include drawing down cash balances at the treasury, taking money from Civil Service funds (retirement and disability), suspending investment into government retirement plans, drawing down the exchange stabilization fund, and suspending state and local government series securities. At the start of 2023, the Treasury had more cash than normal in their general account as tax receipts have increased sharply over the pandemic due to inflated asset prices; however, since the start of the year, these accounts have been drawn down significantly, and are quickly approaching zero.
In response to inflation rising above trend, the Federal Reserve began unwinding its balance sheet in March 2022. This process is typically referred to as Quantitative Tightening, which means that as bonds on the Federal Reserve’s balance sheet mature, money is no longer being reinvested in purchasing additional U.S. Treasuries, so another buyer will need to step up and purchase those assets.
Refilling the General Account
Once the debt ceiling issue is resolved, the Treasury Department will need to issue more debt to refill the general account to the tune of about $500 billion, in addition to restocking the money taken out of government employees’ retirement accounts. This comes at a time when the Federal Reserve is no longer a forced buyer of U.S. treasuries, meaning the market price (the yield) of U.S. treasuries will likely increase to attract additional buyers of U.S. debt.
The Crowding Out Effect
The U.S. can fund itself in three ways: raise taxes, issue more debt, or cut costs. When governments borrow money, they compete with everyone else who also requires funding, leading to interest rate increases throughout the economy. This is a process called the “Crowding Out Effect” and depends on the economy’s ability to accommodate additional borrowing. The government’s tools to fund itself are recessionary as higher taxes reduce spendable income, reduced government spending reduces GDP, and increased government borrowing raises the cost of capital and reduces private sector demand for loans economy-wide.
2022 Gilt Market Meltdown Example
In 2022, the United Kingdom budget expanded significantly to cover increased energy costs due to the war in Ukraine. In addition, it contained significant tax cuts meaning the entirety of the package would be financed by additional borrowing. Due to the crowding out effect, this raised interest rates significantly, causing the gilt market to seize up and the British pound to lose value as market liquidity evaporated. Pension funds were
highly leveraged, and the sudden increase in interest rates threatened to bankrupt them. This necessitated the Bank of England to resume Quantitative Easing, drastically reduce interest rates, and purchase government debt. This caused a political meltdown, and a new U.K. government was formed, with Liz Truss being the shortest serving U.K. prime minister due to this policy.
Refilling the Treasury General account will occur, leading to a crowding out effect of other financial assets (stocks, bonds, and real estate). Tax receipts are closely associated with the capital gains from the sale of these assets, meaning lower expected tax receipts in the future. In addition, the instability in the U.S. banking sector has fewer banks and other financial institutions loading up on U.S. debt. This points to higher borrowing costs for the U.S. government, which raises the “risk-free” interest rate market wide. This may necessitate the Federal Reserve to restart Quantitative Easing and increase its balance sheet as market conditions tighten more than intended.
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