Jan 11, 2023 - Economy

Why debt ceiling risks could be real this time

Speaker of the House Kevin McCarthy (R-Calif.) arrives for a GOP caucus meeting at the U.S. Capitol yesterday. Photo: Chip Somodevilla/Getty Images

Since the modern era of fiscal standoffs began in 2011, the best advice you could give an investor, or anyone making major financial decisions, would be to ignore it.

  • If you just assumed that Washington drama over the debt ceiling and government shutdowns would work out eventually, and that the impact would be short-lived, you would have been right — in the past. But there are warning signs this time could be different.

Why it matters: A self-inflicted fiscal crisis could come at a terrible time amid a fragile U.S. economy, and undermine a Treasury market that underpins the world financial system.

Driving the news: Republicans have claimed a razor-thin majority in the House, and the GOP caucus includes a significant faction of "burn-it-all-down" policy nihilists.

  • The 15 votes it took for Kevin McCarthy to be elected speaker and the concessions he made to hard-liners to prevail show how little control he, or anyone, has over the House.
  • When the U.S. government hits its legal debt limit, likely in late summer or fall, House Republicans may refuse to raise it without extracting major policy concessions that Senate Democrats and the Biden administration will be loath to agree to.

State of play: That would put a U.S. debt default on the table, a repeat of the summer 2011 standoff that sent stocks gyrating wildly, and triggered a downgrade of the nation's credit rating.

  • "The debt limit is going to be a problem," Goldman Sachs economist Alec Phillips wrote in a note this week, saying that they view the situation as a "greater risk than at any time since 1995 or 2011."

Between the lines: There is a sort of reflexivity between Washington and Wall Street in which turmoil in financial markets tends to focus the minds of Congress, acting as a forcing mechanism that helps negotiators forge consensus.

  • The 2011 debt ceiling episode is one example. Another is the failed House vote on the Wall Street bailout bill in October 2008 that sent markets reeling — which in turn added pressure to pass the legislation with some tweaks.
  • But financial markets have become complacent about political risk, precisely because that has turned out to be the proper stance in one episode after another over the last 12 years. Traders who reacted to the latest Washington headlines tended to lose money relative to those who took the long view.
  • As long as markets don't show alarm about a possible debt crisis (and right now they don't), there is less urgency to find a bipartisan path forward. That makes darker scenarios more plausible, such as if the U.S. government were to stop paying some of its bills, or the legal status of newly issued debt came into question.

What they're saying: "In order for Congress to act expeditiously, there must be a sense of gravity around the consequences should they fail to act," Liam Donovan, a principal at Bracewell LLP, tells Axios.

  • "At this point, conventional market wisdom is actively undermining that sort of pressure by projecting unmitigated confidence that it will all work out," he said.

The bottom line: The sanguine outlook on Wall Street makes it more likely that some ugly days may be in store later this year.

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