The Debt Ceiling Explained

The US debt ceiling or debt limit is a popular topic when it comes to government spending. Although, it is not just important to Americans. It can impact the broader markets and investors can see its effects. Michael Normyle, Senior Director of Economic Research at Nasdaq joins Cassidy Clement, IBKR’s Senior Manager of SEO and Content to discuss.

Summary – Cents of Security Podcasts Ep. 50

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement 

Welcome back to the Cents of Security podcast. I'm Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers. Today, I'm your host for our podcast and our guest is Michael Normyle, Senior Director of Economic Research at NASDAQ.  

The US debt ceiling or the debt limit is a popular topic when it comes to government spending, although it is not just important to Americans, it can impact the broader markets and investors can also see its effects. In today's episode, we're going to discuss the basics of the debt ceiling. Welcome to the program, Michael. 

Michael Normyle 

Thanks for having me. 

Cassidy Clement 

Sure. So since this is your first time on this podcast, we generally have a little bit more of a intro to finance audience or a beginner audience. New to the scene, if you will. So what exactly is your background in the industry and how did you get to where you are? 

Michael Normyle 

Sure. So I've been working on the Economic Research team at NASDAQ for about 2.5 years now, so my day-to-day is generally focused on US macroeconomics. Of course, the debt ceiling, you know, comes into play there every so often when it's up for being changed.  

I do spend some time on equity market microstructure research as well. Prior to that, I spent ten years working in macro forecasting at the Economic Cycle Research Institute, where the primary focus was forecasting business cycles and inflation cycles for the 22 largest economies in the world. 

Cassidy Clement 

So you seem pretty well-rounded for this conversation. 

Michael Normyle 

Hopefully, yeah! 

Cassidy Clement 

Yeah. So to kick it off, the debt ceiling or the debt limit. Usually that's something that comes up a lot in conversation about the US government and maybe if people are talking about bonds. But how exactly would you describe the debt ceiling to somebody just learning finance? 

Michael Normyle 

The simple way to put it, it's just the limit on the amount of money that the US is allowed to borrow to fund the government and meet its financial obligations, including things like interest payments on debt.  

So if you want to think of it from a personal finance perspective, it's almost like your credit limit on a credit card. So that's the most money you can borrow, and also you have to pay interest on what you borrow. You can request to increase your credit limits. So all those things have kind of analogous relationships to the debt ceiling. Unlike the Federal Government, though, you can't print money to pay off your credit cards, unfortunately. So that's the one big difference. 

Cassidy Clement 

Right. So obviously we're talking about this in the broader scheme of the country of the United States.  

But my research.. It has been raised or held at different times to hope to avoid default for the country. And then another piece that kind of comes in, which we'll talk about a little bit later is kind of the government shutdown area.  

But when it comes to the actual idea of this ceiling or this limit, why is it in place? If, like you said, there's just a way to put more money into the system? Why have it there if there's a way out? You know what I mean? 

Michael Normyle 

Yeah, I think that's a good question. And honestly, you could argue that having a debt ceiling causes more problems than it solves, in a sense.  

The US is relatively unique in having a debt ceiling that requires congressional approval to change it. In other countries that do have debt ceilings, they can be automatically increased or they're done in a routine manner. For the US, though, we have a debt ceiling because the US government typically runs deficits, meaning it spends more money than it takes in, and so it needs to borrow money by issuing debt like Treasury Bonds to fund the gap between what it spends and what it takes in. And so this puts a limit on how much the government can borrow. So you know, you can't just have unlimited spending from the government. This kind of prevents something like that from happening. 

Cassidy Clement 

Who exactly are they borrowing from? 

Michael Normyle 

It can be really anybody, right? The mom and pops can buy treasury bonds or it can be hedge funds or investment banks, whomever. And not just people in the US, too. There's an international market for U.S. Treasury bonds. So there's a lot of people outside the country.. of course, the US government, our credit is very highly rated and a lot of people think as the biggest economy in the world, it's very unlikely that the debt will be defaulted on. So it's a very safe. Safe investment it's considered. 

The debt ceiling dates back to World War One. And prior to that, Congress had authorized each instance of debt issuance from the Treasury, but to give the Treasury more flexibility in managing federal finances, the Second Liberty Bond Act 1917 was passed. And then by 1939, the debt ceiling starts to look more like we have today where multiple limits were consolidated into a single borrowing cap. 

Cassidy Clement 

So you mentioned limits in there. It would seem like we have a cap on how much the country could borrow, but could that debt ceiling rise? Because that was a popular topic this summer about raising the debt ceiling or the debt limit. Could it rise? And how exactly does that happen? 

Michael Normyle 

Yeah. So there's really three options. It can be raised, it can be suspended and it can actually be lowered. In fact, at the end of World War Two, it was actually lowered. But in recent decades, where the government regularly runs deficits, the debt ceiling generally needs to be increased occasionally as the outstanding debt approaches the current ceiling.  

And so if Congress can’t agree on a specific number, that's when they can suspend it. When it's suspended, the government can issue debt without a cap. And then when the ceiling eventually is reinstated, it's increased above the current amount of debt. 

To increase the debt ceiling, though, it takes Congressional approval, and since 1960 they have increased the debt ceiling nearly 80 times. So it's a regular occurrence, but for most of the history, Congress has increased the debt ceiling. As a matter of course. 

Since 2011, though, we've had a few instances where it's become a bit politicized. In August 2011, Congress only increased the debt ceiling just days before the government would have run out of money, and that date is known as the X Date, and that led to the S&P credit rating business downgrading US credit from AAA to AA Plus. And referencing political brinksmanship as a reason there.  

We saw similar situations in 2013, 2021 and 2023, when the debt ceiling was suspended in June through the end of this year and it was extended through the end of this year on purpose to be after the next Presidential Election. But that 2023 experience also saw another credit rating agency, Fitch, downgrade the US credit rating to AA plus from AAA. 

Cassidy Clement 

So, without getting political at all here, from a strictly economic perspective, what are the pros and cons to raising it? 

Michael Normyle 

It's just that we need to because we run these deficits. There's certainly good reasons to run deficits as a government. If you’re making investments in infrastructure and things like that, for example. These things, they're very big upfront costs, but they pay off for the economy over the coming years and decades, and it can pay off in higher GDP growth through increased productivity. If you're, for example, going from having no kind of highway system to building a nationwide highway system that really helped with transporting goods around the country. Those types of things.  

So it's necessary, oftentimes, to run a deficit. Also, if the government were to go from running a deficit to not running a deficit, it would even need to be through increased tax or cutting spending dramatically, which would negatively impact GDP, probably costing people a lot of jobs. So there's a lot of reasons to run a deficit, and in doing so you need to borrow money and you need that debt ceiling in place. 

Cassidy Clement 

Got it. So when we're talking about this government, I don't want to say control, but kind of the government's deficit here at for the US at least. This debt ceiling or debt limit is impacting a whole lot. It's more than just the people in office not getting along, it's also government programs and other types of spending and other types of money flow throughout the country and then potentially other countries who do business with us.  

So how does the debt ceiling correlate to the government operating and a potential government shutdown? 

Michael Normyle 

Well, so the debt ceiling and government shutdowns are kind of two separate things. The debt ceiling is a limit on how much the government can borrow. A government shutdown happens when the money to fund the government hasn't been appropriated by Congress, even if the debt ceiling has enough money to provide that funding. Congress has to pass new legislation each fiscal year to fund the government. If they can agree on a full year funding bill, we can see non essential parts of the government shutdown, including furloughing of employees of those agencies. Alternatively, Congress could pass stopgap funding bills called continuing resolutions or CRs that fund the government for as little as one day, but often weeks or months to give congress time to negotiate on a bill to fund the government for the rest of the year. 

Cassidy Clement 

So how would investors start to see their day-to-day life, country, investments, portfolio get impacted if the country gets close to this debt ceiling or as you mentioned there was like the possible suspension or what have you. How exactly would the day-to-day investor see this impact? 

Michael Normyle

Well, if investors in general are confident that the debt ceiling is going to be raised without much of an issue, it honestly doesn't have much impact on markets. The potential impacts happen when investors start to price in a chance that the government reaches the debt limit. And like I said earlier, there were four recent times when that happened where people were at least a little bit concerned that a debt ceiling standoff could result in a default. So that was 2011, 2013, 2021 and 2023. And so the concern stems from the risk that the government defaults on its debt. And if that happens, then the US will become a much riskier borrower. So earlier I was talking about people internationally pay for U.S. Treasury Bonds because the US is seen as such a low-risk borrower.  

But if we do default on our debt, then that changes. And so people expect that if the government were to default, we'd have to pay higher rates on future debt, given that increased credit risk.  

And so beyond that, it would also be problematic for the economy. During the 2023 standoff, Moody's estimated that just a week's long breach of the debt ceiling would cause an almost immediate and severe recession, resulting in seven million jobs lost and a nearly 20% drop in equity prices.  

And that's because no longer able to spend more money than it takes in, the government would have to slash its spending immediately, cutting about $350 billion in deficit spending and furloughing government workers without pay.  

So looking at how markets reacted to the debt ceiling issues in the last 13 years, the most consistent impact we see is on short term treasuries. And so yields on short term treasuries rise sharply in the days and weeks ahead of the X date or the date when people expect that we would potentially run out of money.  

Because those are the treasuries most at risk of defaulting, since they have potentially matured during the time when the government hit its debt limit and can't repay those lenders.  

So to compensate borrowers for this higher risk, we see higher interest rates on those short-term treasuries. But then once the debt ceiling is resolved, they quickly revert to normal yields. Long-term yields are generally unaffected though, since they're not really at risk of defaults related to the debt ceiling. And then for stocks, we did see sell offs ahead of the 2011, 2013 and 2021 X dates due to uncertainty caused by the debt ceiling stand off.  

Once the debt ceiling was resolved, stocks rose again, except in 2011, where that S&P downgrade I talked about earlier, of the US credit rating, continued the sell off a little bit. 

Cassidy Clement 

Just completely hypothetical here. If the US was to default on these debts or bonds, what are like some bullet points that would happen? 

Michael Normyle 

Well, I guess in a sense, it's kind of hard to predict because it's never happened before. But I think the short-term issue is, is that the US would have to pay higher interest rates on its debt, which is a problem because we already have a significant government debt load and it's projected to keep rising.  

So we've recently passed the point where government expenditures on net interest is the third largest expenditure after Social Security and Medicare. So seeing money that's being just spent on interest, you can consider it almost as unproductive money being spent, really, because if we didn't owe that interest then all those billions of dollars could be spent on, you know, like we talked about earlier, building highways, building tunnels, whatever.  

So we would be dedicating more and more money to kind of unproductive things essentially. So I think the risk that you have is that you have a higher interest rate that you're borrowing at and let’s say headwind on long term growth. So that could ultimately reduce kind of the economic trajectory of the US economy, so really best avoided. 

Cassidy Clement 

I mean right, it makes sense. You don't want to see any government defaults on any of their debt or loans, but from the perspective of purely education, just to show the ripple effects, that's kind of why I bring that up. I mean, not to look for a headline too much, but it's only so American that America has so much debt, just like all of its citizens. America has so much debt, so it makes sense. Yeah. So thanks for joining us today, Michael. 

Michael Normyle

Right, right. I really appreciate it. Thanks for having me.  

Cassidy Clement 

Sure. So as always, listeners can learn more about an array of financial topics for free at ibkrampus.com. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening everybody.