The US Debt Ceiling –A Dangerous Game of Chicken.

The FED has come out to say that the US will technically run out of money on 1 June and may default on its debt obligations if an agreement is not found in the coming days. This would be a watershed moment in US history if it was to occur and would send global markets into a frenzy.

So, what has led us to this point?

Post financial crisis of 2006/07, it became unfashionable to worry about the long-term fiscal outlook. Inflation was extraordinarily low and interest rates were set low in response. Post-2008 worries about inflation from QE proved misplaced. High inequality, post-financial crisis economic slowdown, and unpopular austerity measures led major economies to adopt a policy of cheap money printing and expansion based on low-interest rates and excess money supply. Terms such as “Quantitative Easing” and “Stimulus Packages” were adopted by all major countries and so began a decade of loose monetary policy and a ferocious appetite for cheap money and finance.

To put into context, the US Government’s increase in Debt over the past two decades has gone from $6.7 Trillion in 2003 to over $31 Trillion in 2023. That equates to approx. $94,000 of debt for every US citizen. Total revenue in the US is currently $4.9 trillion per annum versus a total expenditure of $6.3 Trillion. Each day the interest bill alone on debt is $1.3Billion.

So why not keep doing what we have been doing for the past two decades and keep printing money and kicking the can down the road for the next generation to sort out? One answer – Inflation.

Any good economist will tell you that if you keep fueling an economy with cheap money which costs less than your 10-year sovereign bond eventually this will come and bite you through a rapid increase in inflation. This is what we are currently experiencing as a result of two decades of cheap money and a bonus stimulus package issued to each American during Covid which resulted in a surge of pent-up demand being released into the market post-Covid.

As a result, we have seen US inflation and Global inflation reach 50-year highs over the past 18 months and Central Banks and policymakers scrambling to stop this runaway train by hiking interest rates at unprecedented levels globally.

By hiking interest rates Global Central Banks have now shot themselves in the foot also as the cost to raise new finance has become 4/5 times more expensive today than 2 or 3 years ago when you could issue a 10-Year Sovereign bond at less than 1%.

This shift in the cost of finance for central banks is causing heated debate and wrangling as Governments and Central banks seek to reign in ballooned debt, and interest costs and look at other measures such as reduced spending or higher taxes to balance their books.

In this context, the 2023 debt ceiling fight feels like an anachronism—Republicans and Democrats fighting to invalidate spending that has already been approved, even after both parties have spent like “drunken sailors”, to use John McCain’s phrase. And the fact that this feels so anachronistic is why we think the current standoff between the Republican Party and the Democrat Party will probably be resolved at the last hour as someone buckles under this dangerous game of chicken. Both sides are in a very different place from where they were in the early 2010s. Nevertheless, this is unlikely to be the last fiscal bun fight in a new era of higher rates and inflation.

Broadly, there are four scenarios for how this debt ceiling skirmish could play out:

a) Most probable, a negotiated deal, involving some spending cuts and regulatory changes,

b) Debt ceiling increases without Congressional agreement (via executive action or an unusual maneuver), which is less likely given the legal challenges that may result,

c) No deal scenario with the prioritisation of interest payments and

d) A vanishingly small probability, no deal with full defaults.The clock is moving to 1 June. Insurance premiums for debt default or credit default have been skyrocketing in the past week.

We believe a negotiated deal is most probable. Firstly, unlike in 2011 and 2013, deficit concerns are not in the foreground today. Secondly, Republicans are less united than in the early 2010s, when their majority in the House was much larger.

The composition of the $3.2tn of discretionary spending cuts in the Local Government Services Act remains undisclosed because Republicans would rather not defend cuts to popular programs.

One thing that is clear from this dangerous game of chicken is that this problem is not going to go away quickly. Although the best-case scenario is a short–term deal now, long-term Central Banks and Governments globally need to ensure that “Quantitative Tightening” or QT becomes a dominant theme in budget setting and fiscal policy as we head into a decade where inflation and interest rates are here to stay.

Please feel free to contact any of the Paragon Team for further assistance and guidance on navigating these times. Remember we have an in-house Economic Team that can provide further detail and insight into the Debt ceiling topic.

We hope you have a great weekend and let’s hope by the time Monday rolls around the above will be old news!