The White House and Congressional Democrats in the House appear close to an agreement that would raise the debt ceiling and approve a new spending bill. Feels like déjà vu.
The deadline for a deal is effectively this week: Congress will begin their August recess soon and won’t return until after the U.S. has exceeded the debt limit in September. Even once a deal is reached, the federal debt and deficit are challenges that will regularly haunt investors. What are the issues and how do they affect markets?
The debt ceiling is a limit on the total national debt imposed by Congress. While its purpose is to instill discipline on government spending, the truth is that budget deficits year-after-year make it inevitable that the debt ceiling will need to be increased periodically. In this way, the debt ceiling is a symptom of unbalanced budgets, not the cause.
Thus, in theory, raising the debt ceiling to pay for government spending that has already occurred should be straightforward. After all, that spending had already been agreed upon and approved. As with all things regarding Washington politics, the reality is not so simple.
Hitting the debt ceiling would mean that the government would no longer be able to pay its bills. A U.S. government default, especially one that is self-inflicted in this manner, would not be good for the global financial system.
A preview of this occurred during the 2011 debt-ceiling crisis when politicians struggled to reach a deal. As a result, Standard & Poor’s downgraded the U.S. debt which triggered a market pullback to near-bear market levels. The market did recover after several months, but this was a hint of the worst-case scenario.
However, not all is gloom and doom. The level of debt and government spending aside, debt ceiling increases since then have been relatively smooth in hindsight. While there may be some market volatility as investors deal with Washington brinkmanship, markets have generally been unaffected in the long run.
Thus, for long-term investors, it’s important to separate our concerns as taxpayers and citizens with those of our financial plans and portfolios. While these headlines may be a source of short-term volatility, they are not necessarily a reason for long-term portfolio adjustment. The national debt will continue to be an issue – but this is a problem that is unlikely to be solved by Washington in the near future.
In the simplest terms, the deficit can only be solved by lowering spending or increasing revenue. There appears to be little political will today to cut spending. On the flip side, tax rates are quite low by historical standards. Eventually something will have to give.
At the moment, regardless of the long-term solutions and consequences, it’s imperative that the government doesn’t shoot itself in the foot by breaching its own rules. Below are three charts that address this long-term topic:
1. Government debt is nearing the debt ceiling limit
The U.S. federal government debt has increased dramatically since the global financial crisis. Total U.S. debt exceeded 100% of GDP in 2012 which was an alarming sign for many investors.
However, a more relevant measure is that of “net debt.” Total debt includes debt that is owed by one part of the U.S. government to itself, akin to moving money from one pocket to another. Net debt excludes this “inter-governmental” debt.
That said, by no means does net debt paint a rosy picture. It has also increased significantly to 77% of GDP, but is not yet at the 100% threshold on which many investors focus.
2. The federal budget deficit continues to worsen
By definition, the national debt increases each year because the country does not operate on a balanced budget. The imbalance between what the government spends and what it collects in taxes each year is the budget deficit. The deficit continues to add hundreds of billions of dollars to the debt each year. There were only four years of surpluses during the 1990’s when the economy was strong.
The glass-half-full view would be that if the patient were critical in 2009 when the deficit hit 10% of GDP, they are still sick today but in stable condition. Deficits of a few percent points can theoretically be solved by Washington if there is the political will to do so.
3. Income tax rates are still low by historical standards
Eventually, if spending isn’t reigned in, the revenue side of the government income statement will have to be addressed. Tax rates – both individual and corporate – are quite low by historical standards. Those investors planning for the future should consider this fact when choosing the right strategies and structures.
The bottom line for investors? While there may be market volatility, the long-term consequences of the debt ceiling have more to do with tax rates and financial plans than short-term trading.