The US is facing another debt ceiling stand-off, with very high stakes for the economy and markets. Paul and Luke talk to James McCann, Deputy Chief Economist at abrdn, and Lizzy Galbraith, Political Economist, about the current impasse and how it could be resolved. They discuss the history of the debt ceiling, the likely shape of a deal, the impact of possible spending cuts on the US economy, and the worst-case scenario of a US debt default.

Paul Diggle
Hello and welcome to Macro Bytes economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn.
Luke Bartholomew
And I'm Luke Bartholomew, Senior Economist at abrdn. 
Paul Diggle
And today we're talking about an important issue in a macro and markets at the moment - the US debt ceiling. So, we're recording this on the 25th of May, we're a week out from the likely X date at which the US Treasury would be unable to issue new debt, raise new funds, cover the ongoing expenses and debt servicing costs of the US government without an increase or suspension of the debt ceiling. And we've been here before in 2011 and 2013, eventual debt ceiling increases, we're done then, but not without financial markets, stresses and strains along the way. And there is always some risk of technical default on treasury bonds, which are after all, the world’s safe asset and indeed a bedrock of the financial system. So how we got here? What might happen next matters a lot to markets and the economy. And we're joined by the right people to talk about these issues. James McCann, our Deputy Chief Economist covering the US and based in Boston.
James McCann
Thanks for having me. 
Paul Diggle
And Lizzy Galbraith, our Political Economist.
Lizzy Galbraith
Hi Paul.
Paul Diggle
So Lizzy let's start with you then. Why don't we talk a little bit about background? Why does the US have a debt ceiling? It's not an issue that comes up in other countries. Why is it part of the fiscal and political landscape in the US?
Lizzy Galbraith
So the debt ceiling in its current form, has existed since 1917. But really, the roots of it goes back to the fact that it's Congress and not the President that has ultimate authority over tax and spending decisions. So, prior to 1917, what's happened is that Congress would be required to authorise every new spending decision that the President made, and every new bond issuance that the Treasury made. And then World War One happens. In 1917, the US joined World War One and all of a sudden they needed to spend lots of money very quickly. And the debt ceiling ironically, was designed to make the lives of Congress easier by letting them sort of pile together multiple new bond issuances in one go rather than the President needing to come back to Congress every single time. So what started off as something that was supposed to actually save Congress time, has, over time evolved into an occasional political sticking point, as we've sort of seen political polarisation in the United States increase.
Paul Diggle
And what you flesh out Lizzie why it's become a sticking point in recent history - in 2011, 2013. How did we get these standoffs? What has to come together to cause this sort of a flashpoint?
Lizzy Galbraith
Yeah, so most of the time, the debt ceiling is raised with very little drama. Most of the time, it's actually a very run-of-the-mill occurrence. And the first time we really saw an example of the debt ceiling being used as leverage in negotiations, is actually 1995, which was under President Clinton. And what happened there is, this might sound familiar for those of you that are more familiar with recent debt ceiling crises, but the Republicans had a very good midterm election. They flipped both houses. And they came into Congress with the aim of exacting fiscal concessions from a Democrat president. We didn't see the level of drama that we have seen more recently than that. But that was the first instance where we did get this idea that the debt ceiling can be used to exact leverage. In that instance, what we actually got was a government shutdown rather than a full-blown debt ceiling crisis. And in the end, Clinton effectively called the Republicans bluff. And we ended up with effectively the Republicans ceding ground to Democrats. In that instance, the first serious crisis, as you pointed out, was in 2011, where again, the Republicans had an incredibly good midterm election season, and came into Congress with a what they felt was a very strong mandate to exact fiscal concessions from President Obama. Coupled with that, you also had a particular wing of the Republican Party, and then it was known as the Tea Party, that was particularly keen on getting these fiscal concessions. So we had the scenario in which we had a Democrat president that was quite keen on continuing on his existing fiscal policy, and Republicans that felt that they had a mandate to make sure that that didn't happen.
In that instance, what happened was three months of very, very contentious negotiations, which started to rattle markets, coupled with some failed votes as well, which didn't help the situation, and a very, very last-minute deal to raise the debt ceiling, but with some very substantial concessions from President Obama as well. So, what we got in that instance, was the Budget Control Act of 2011, which reduced spending over a 10-year period by over $900 billion dollars, in exchange for raising the debt ceiling. 
Republicans tried this again, in 2013, which was the next debt ceiling raise that needed to take place. And they tried to exact similar policy concessions that time around as well. The difference on that occasion was actually that the public backlash caused Republicans to back off. So although we had a similar timeframe, in that the debt ceiling raise itself was incredibly last minute and done on the date of the X date. The reason that we sort of got the solution in the end was actually the political cost to Republicans was higher in that scenario. And that's actually something to watch this time as well, whether or not public backlash starts could build against against one or both parties because of the way that they're conducting negotiations. But we have only really had these three instances of sort of genuine drama over the debt ceiling. And what tends to be the sort of the magic formula for that to take place is a Democrat president, with at least one chamber being controlled by Republicans that are quite keen to gain spending concessions.
Luke Bartholomew
So Lizzy bringing the story up to date, we're recording today on the 25th of May, which is significant, because it's one week before the first of June X date that, at least Janet Yellen has suggested will be the point where the US runs out of an ability to meet its obligations. So obviously, things are moving relatively quickly, as one might hope. But can you give us a sense of how the negotiations are currently shaping up, what the different parties are looking for and what a likely landing zone might be?
Lizzy Galbraith
Yeah, so negotiations have been going on for a relatively short period of time, given where the X date is. So we've only had a couple of weeks of really detailed negotiations so far, which means we only really get a month of negotiating time from the start of those negotiations to the estimated X date. That's relatively short by historical standards. And that's reflective of the fact that Congress has been taken slightly by surprise, by this X date. They were expecting it to be later in the summer and therefore hadn't really begun negotiations by the time that Janet Yellen came with this warning that the X date was going to be on June the first rather than later in the summer.
The first thing that happened was that Republicans did successfully pass a bill that set out their negotiating priorities. That was sort of symbolically important, given that it demonstrated there was a majority in the House for some form of solution to this. However, that solution involves $4.5 trillion of spending cuts over 10 years. And it targets some key Democrat priorities. So, although they've managed to demonstrate that they can get this to the House, it absolutely wouldn't get through the Democratic-controlled Senate. And it's certainly not something that President Biden is going to be willing to sign on to either. So that's essentially the Republican starting point. The Democrats’ starting point was actually a clean debt ceiling increase with no spending concessions. So, at the moment, the negotiations centre on where the middle ground can be, between 4.5 trillion and zero. There's four key areas that the negotiations are focusing on at the moment. So first of those is the 2024 budget. Republicans would like that to go down to something like 2022 levels. Democrats are looking to hold spending it 2023 levels and argue that that would be in effect in real terms cut. In the end, we're probably likely to get such as something closer to the Democrat ask in this instance, particularly because Republicans are looking to actually increase defence spending. So to balance that we're likely to see something closer to that ‘23 figure, but we're probably going to see some additional cuts in certain areas of spending, particularly additional work requirements for some benefits programmes, particularly food assistance programmes, which are a key Republican ask. The other big area of negotiations is around spending caps for more medium-term spending. So, the Republican ask there is for around about 10 years of spending caps where the government would be allowed to increase spending by 1-2% each year. The Democrats are trying to increase the generosity of that cap, as well as reduce the duration of that cap, as well. So there's a lot still on the table, there's very little that has actually been formally agreed. And as you said, we do only have a week to go. And once you take into account the time that it's going to take to actually pass the legislation, we meaningfully actually only have a few days of negotiations left. And that means that it's a very real possibility that instead of a full deal, we're going to actually get a short-term extension of the debt ceiling to allow for these negotiations to continue.
Luke Bartholomew
So it seems the Democrats have largely given up on the idea of a clean lift where the debt ceilings increase without any spending reductions. But as you say, given how much it touches on certain key democratic priorities, and in their mind legislative achievement, what the Republicans are asking for is also not going to get through either. So I know this is very hard to say precisely, but do we have a sense of where the rough landing zone will be - in terms of the quantity of spending cuts that are likely to be passed?
Lizzy Galbraith
I think we're probably going to end up meeting in the middle in many respects. So I would still expect spending cuts of around something between two and one trillion to be agreed overall, but I think that you're going to see those less targeted towards some of these key Democrat areas. So for example, one big ask in the original Republican bill was a very significant cut of funding for the Inflation Reduction Act, which is a real flagship policy of the Democrats and something that President Biden's going to really want to campaign on in the presidential election next year. That's very, very unlikely to actually end up being in the eventual package of measures. And I think what's more likely is that the real meat of the savings is going to be around these spending caps, that would give the government a bit more flexibility over how they choose to target that funding without having to strip out the funding for their key priorities.
Luke Bartholomew
So James, bringing you into the conversation. Lizzy was talking there of one to $2 trillion of spending cuts being perhaps where the deal ends up being made. What kind of impact would those spending cuts have on the economy? I mean, many of our listeners will know that we've been forecasting a US recession for the second half of this year for some time. Does the debt ceiling negotiations, the way in which this whole thing has been handled, and indeed the likely deal - how does that impact our assessment of the likelihood of a recession?
James McCann
Absolutely, well, I guess what it implies is we're going to get some degree of fiscal tightening over the next, you know, immediate, short-term future and then over a longer budget window that clearly adds to the significant monetary policy tightening that we've had, and obviously, the banking stresses that are going on. So it's another headwind for growth. In terms of quantifying that, you know, Lizzy did a great job of outlining where both parties are sitting, where the middle ground might look, that 1 trillion to 2 trillion middle ground, we have to remember is spread over a 10 year budget horizon. If we try and think what might come in fiscal year 2024, which starts in just a few months, I think that's most relevant for our forecasts. If the Democrats were to get a freeze in non-discretionary spending caps, then you're talking around 30 billion of effective cuts. Republicans, as part of their bill had asked for around 150 billion, so there's a fairly substantial difference. We'd probably expect this type of government spending to have a decent-ish multiplier. So if I and try and put those pieces together and think of a middle ground, you know, I'd probably come up with a little bit of a back-of-the-envelope calculation, and this will be a drag of between 0.2 and 0.4 percentage points off growth. So something, and sorry, that’s growth over a calendar year. So that's something that's not insignificant, that's a decent headwind, but something that’s not on its own shaping fundamentally the outlook. So, I think this is an additional headwind that we set alongside the monetary policy tightening alongside the banking stress and issues we have there, to make us more concerned about the US cyclical outlook. 
Paul Diggle
James, in our scenario analysis of possible debt ceiling deals or indeed failures to strike a deal, what we've been talking about so far, either a short-term extension, or a deal that raises the debt ceiling, with the consequences that you Lizzie been talking about, that occupies something like, say 90% of the probability distribution. One of those types of scenarios is more likely than not - and historical precedent is for that down-to-the-wire deal, which is not without market stress and strain along the way, and economic consequences afterwards. But let's talk about the kind of more ‘tail risky’ parts of the distribution, which is actually a week from now the debt ceiling is not raised or suspended, and the US does actually pass the X date. What do those sort of scenarios look like? We're very much into uncharted territory. But one of the ones we've designed ,James, we call this the TARP 2.0 scenario. Do you want to talk us through what that means?
James McCann
Yeah, absolutely. And this is a call back to the financial crisis and the failure to pass that TARP legislation and the resulting financial market fallout that pretty quickly sharpened the focus to get that deal done. I think we'd see a similar dynamic playing out here. The implications of passing the X date are that you’re not able to meet all your obligations. I think it's clear that in the near term, the Treasury will prioritise, as discussed, payments to bondholders to try and prevent the quite damaging, you know, ‘financial plumbing’ issues that might arise from a more formal style Treasury default or missed coupon payments. But it still means that you're not paying domestic creditors. You're not paying contractors, you're probably not paying payrolls for federal employees, social security checks might not go out. So there are still short term consequences and markets, having seen you've gone past the X date, would definitely be very alarmed that this could become a more prolonged and damaging stasis. So I think when we speak to colleagues within investment teams, I think there's a consensus that the market reaction could be quite severe, significant declines in equity markets over a short space of time, widening credit spreads, a great deal of financial stress coming through the system. And we would expect all that noise, or probably noise is the wrong way to describe it, or that financial stress, to really catalyse an agreement and probably we'd expect Congress to come back and pass something within a relatively short timeframe of let's say, 48 hours. Even having done that, though, we do think there'll be some lasting damage from that, both in terms of the short term fallout from all that tightening in financial conditions and the hit to business consumer financial market confidence, but, you know, also, again, just a further knock to the credibility of US political institutions and their ability to sort of manage their own fiscal affairs. 
Paul Diggle
Yeah. And just to spell out ‘TARP’ for those that maybe don't know, that was the Troubled Asset Relief Program. It was one of the bailouts effectively in the teeth of the financial crisis where exactly this dynamic of not passing it on the first go and then a quick reverse for it amid market stress meant that it was passed on the second ask. But what about James then in the scenario where even that is kind of too optimistic? So we're very much into the ‘tails’ now, but let's at least think about it. What happens in a situation where the X date is breached, and there isn't even this say 48-hour turnaround in which market pressure forces a deal and actually, the US is in sustained default over weeks or months. What does that look like from a macro market perspective?
James McCann
We certainly head into almost uncharted territory there. I think we can be confident though, that it would look really, really bad. Certainly, the prioritisation of payments to avoid the stress and pressure falling on bondholders – that becomes increasingly challenging and potentially untenable as more coupon payments are due, more redemptions are due, more bills are being refinanced. I think that becomes deeply problematic and the risks that you do miss those payments becomes very large. The missed payments to domestic creditors, we spoke about contractors, we spoke about government employees, we spoke about social security recipients etc. They start to accrue too. And the financial market fallout I think is very severe as well. As you mentioned, Paul, US Treasury is the bedrock of the global financial system. And I think defaults on those would obviously unleash a huge chain of, of feed through effects into other assets. The significant uncertainty that would unleash as well around the outlook for the US economy, for global macro. Now, if we think about the economic implications, you're probably looking at a very severe recession. If you're looking at the market implications, again, discussing this with colleagues across the firm, we're talking about really material drawdowns in equity markets, very, very significant widening in credit spreads, a degree of stress on the dollar and perhaps, unintuitively maybe, but some degree of safe haven flight into US Treasuries themselves. And as well then pricing a lower path for interest rates, as the market anticipated that the Fed would have to cut interest rates very significantly, and keep them at the lower bound, maybe even start asset purchases, too. So these are all very, very sort of dramatic, dramatic outcomes. But I think when you're considering a default from the US government and a willing default, not because the market has forced them to but because they can't get their political house in order, I think the ramifications are very painful. 
Paul Diggle
Lizzie talking about getting political houses in order, I wanted to ask you a bit about the party incentives on each side of the aisle here, because you referenced the 2013 backlash against the Republicans for taking debt ceiling negotiations down to the wire then. Obviously, this current standoff occurs in the early stages of Republican primaries, and then the US presidential election next year. So, party politics are obviously a key part of the calculus here. How are both sides thinking about how this standoff plays into their political priorities and their positioning ahead of the presidential election?
Lizzy Galbraith
Yeah, that's been quite interesting to see evolve over the last few weeks actually. And as you would expect, there's quite a spectrum of opinion within both parties, not only just in terms of their messaging, but also in their sort of preferred, or expected outcomes from these negotiations as well. So on the Democrat side, they've been very keen to sort of portray their party as being responsible and trying to move negotiations forward without very damaging cuts to spending. And they've been very keen to portray the Republican asks as being very strongly influenced by the right of the party and the MAGA Republicans that they're quite keen to paint the party as being ahead of the 2024 elections. So they're quite keen to say, well, these asks are too far to the right, like they're not feasible, they'll cause more economic damage than then they'll help solve. And that's very key to their argument at the moment. On the Republican side you've had Kevin McCarthy essentially say the same thing in reverse that, you know, the Democrats are addicted to spending, that they're too strongly influenced by the left of the party, and that they're moving towards, you know, a more sort of socialist style of politics and Republicans are trying to be responsible by containing future spending. And at the moment, the polls sort of effectively say they're both right. The polls reflect a public concern about missing the X date and concern that there will be significant damage to the economy in that instance. But they do also show that around 60% of Americans want to see spending cuts as a trade-off in these debt ceiling negotiations. So both sides are at the moment sort of taking what they want from the public reaction. That's not likely to remain as forgiving as we start to see stress build both in the markets and also within the American public as well. And the negative perception of politicians that you tend to get towards the end of these debt ceiling crises, can be a quite important motivator, particularly, as you've said, in the run-up to a presidential election. So it's potentially quite a significant thing to watch in the next week or so to see which side the public comes down on. But there's certainly a very broad swathe of opinion across both parties. And then on the Democrat side, there are still plenty of people in the House in particular that are very opposed to spending concessions and believe that Biden should be doing more to try and advocate for that clean debt ceiling increase. And similarly, on the right of the Republican Party you have people that say, you know, it doesn't matter if we miss the X date by a little bit, it's probably not June the first anyway, so we don't need to be too concerned. Really the majority opinion is in the middle ground, far away from both of those ends of the spectrum. And both parties are in the majority interested in finding a bipartisan solution to this. But managing those two wings on the edges is going to be really important over the next week and is really crucial to actually getting a majority for any deal and going forward as well.
Luke Bartholomew
So Lizzie, given the difficulty in finding an agreement that you've talked about, and the catastrophic consequences that James sketched out about a sustained period of default, or indeed even a short period of default, and I suppose also the desire amongst some people to break this cycle whereby the debt ceiling can be used as an important point of political leverage and negotiation tool to get spending cuts that may not be able to be passed in other ways, there's been a lot of discussion around other  schemes or devices that can be used to circumvent the debt ceiling in some way. So there's been this discussion of a $1 trillion platinum coin that could be minted by the Treasury, and then deposited at the Fed and drawn against and that would give the government financing, or perhaps the administration could invoke the 14th Amendment, or maybe premium bonds could be issued. So perhaps you could just say a few words about what these schemes actually involve, whether they would solve the issue and really what the chance of them being utilised is?
Lizzy Galbraith
Yeah, so there's been a fair few proposals, particularly in this round of debt ceiling negotiations put on the table, about alternatives to going to Congress, to seek a bipartisan solution to the debt ceiling raise.
All of them come with very significant political costs. And that's why in all cases, the preferred option of the President is going to be going to Congress and seeking a bipartisan solution. So all of these proposals, although some of them are technically possible, are quite improbable, absent a very severe crisis. So while passing a bill through Congress is still an option, that's likely to be the preferred option for Biden. However, some of these are not technically impossible. So the first you mentioned, I mean the 14th amendment has sort of grown in popularity as an option in recent years. So this a scenario in which the President signs an executive order to effectively circumvent the debt ceiling by invoking the 14th Amendment, which states that the validity of the public debt of the United States cannot be questioned. So that's essentially saying that the President has the power to override Congress's tax and spending powers when it comes to public debt. It's one that's that sort of gone back and forth among legal scholars as to whether or not it's actually a viable solution. And in this instance, although it's possible that Biden could sign an executive order, if we moved past the X date, and a congressional solution was not forthcoming, it would almost certainly spark a legal battle and a sort of constitutional crisis over presidential powers, and how the executive and Congress work together. So although it would potentially avert an immediate sort of fiscal crisis, you may well be opening up a serious can of worms there with regards to constitutional law, it would almost certainly end up in the Supreme Court. And the risk of it being overturned is relatively high. A legal case actually ruling on the 14th Amendment is going through in the US at the moment. There's a group of federal employees that are currently suing the government, arguing that Biden should proactively use the 14th Amendment to ensure that they get paid on time, essentially. So we will have a legal ruling on the use of the 14th Amendment, but not in time for June the first. So this argument is going to be decided upon, but sadly not in time for it to be of use in this current debate.
The other two that you mentioned - premium bonds - using premium bonds to raise government funds.
This is in a situation in which you'd get an expiring premium bond which would be renewed by the government at a higher coupon rate to raise funds and could push the X date out further to give the government more time. So this is a solution that hasn't really been endorsed by the Treasury or either party, it's sort of being seen as a bit of a gimmick.
However, a bit like the 14th Amendment, it's likely to be possible in practice, although letting the Treasury do this would have very significant negative political consequences for Biden. And again, it's likely to be a real sort of break glass sort of solution to the crisis. Also, in that category of being really a last solution to a real economic crisis is this idea of minting a trillion-dollar coin. So the Treasury does have the legal power to mint coins in any denomination it chooses. So this idea basically says that the Treasury can mint a trillion dollar platinum coin, and then deposit it at the Federal Reserve. The Fed then credits the Treasury's account with the funds, and the debt ceiling crisis effectively goes away.

Again, this is this is not something that's been endorsed by either party, Janet Yellen has rejected this as a solution to the debt ceiling. And it does have, again, very significant negative political consequences. So in addition to the obvious potential inflationary impacts that it may result in, it would also drag the Fed into a very partisan political debate. And that's something that it's going to really want to avoid if it possibly can. So while all these solutions are potentially technically viable, if you are really looking at the alternative, the alternative being a sort of a genuine economic armageddon, they do have very significant political consequences that mean they're unlikely to be used as a pre-emptive solution to any debt ceiling negotiation.

Luke Bartholomew
Well, let's hope they're not necessary then. And with that, I think that is all that we have time for this week. So all that remains is for me first to ask you all please to like and subscribe on your preferred podcast platform. And then to thank Lizzy and James for their excellent insights, and to thank you for listening. So thanks very much and speak again soon.

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for information purposes only and should not be considered as an offer investment, recommendation, or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provides no guarantee of future results.