How Debt Limits Could Lead To A Black Swan Event For Wall Street
How can fiscally conservative legislators vote for more spending while simultaneously expressing dissatisfaction with the debt this spending harms the country's future? By coming up with an amazing political process -- having debt ceilings or statutory limits and separate the votes on spending and the assumption of debt necessary to pay for that spending.
That's according to Nicholas Creel, Assistant Professor of Business Law at Georgia State University, who says the dichotomy dates back more than a century.
"The U.S. Debt ceiling is a product of a political compromise in the World War I era," he told International Business Times. "It was crafted as a way to allow fiscally conservative Congressmen to vote for the prolific spending that was required to fund the U.S. effort in World War I while also giving them a formalized way to express dissatisfaction with the debt this spending required us to take on."
To compromise these opposing goals, Congress separated the votes on spending and the taking on of debt necessary to pay for that spending. "It allowed those members of Congress to take a symbolic stance against the policies they just voted to support," he added.
"It was, in a word, theater," Creel continued. "This is the exact reason the debt limit continues to this day; it gives Congressmen on both sides of the isle a way to object to spending they disagree with but do not want to expend the political capital to curb it."
The politics surrounding the debt ceiling become contentious, as some members of Congress may use the need to raise the limit as leverage to push for other policy changes. Moreover, they can become dangerous for the U.S. economy if Congress fails to raise the debt limit and the country cannot pay its debt obligations.
While that hasn't happened thus far, there's always a slight possibility of going into default. In that case, it could turn into a "black swan event," fueling panic in global financial markets.
"A debt default would be a disaster for the U.S. and world financial markets," said Joe Urban, Managing Director of Electronic Trading at Clear Street. "While not a one-to-one comparison, we can look to the U.K. financial crisis, which included sharp yield increases in bonds, and the shortest U.K. government in history, as a model for how this scenario could play out in the United States."
Urban suggests that market participants watch U.S. treasury credit default spreads, repo liquidity, changes to bills, notes, and bonds, and monitor for short rates. They can signal nervousness in the market.
Still, Creel thinks President Joe Biden has a few ways out of a debt ceiling debacle.
"For one, he could rely on Section 4 of the 14th Amendment, which reads that "The validity of the public debt of the United States, authorized by law...shall not be questioned,' "he explained.
"Unfortunately, it is difficult to read that plain language as anything other than a strict prohibition against refusal to pay our debts, meaning he could disregard the debt ceiling as unconstitutional and force Congressional Republicans to sue him to overturn his actions."
Most lawmakers and economists hope it doesn't come to that, but the drums are beating louder in the Republican-controlled House to stop spending at any cost.
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