This Debt Ceiling Showdown Is Especially Risky

Gilson: Could new Speaker of the House Kevin McCarthy craft a similar deal to end the current showdown?
Malhotra: Fast-forward 12 years. The question is, would those same dynamics apply? There are a lot of reasons to believe they won’t. The speaker is a lot less powerful. Would Kevin McCarthy ever allow a clean-ish debt ceiling vote to get onto the floor?

Keep in mind that President Barack Obama gave up a lot to get the 2011 debt ceiling deal done: Congress passed the Budget Control Act, there was sequestration, and there were budget cuts. The Democratic Party was much more moderate in 2011 than they are today, so I think the Democrats would be very unwilling to negotiate spending cuts.

Is Biden willing to negotiate at all? We don’t know. Would McCarthy ever put something on the floor that would cause the majority party to get rolled, and would that jeopardize his leadership if he allowed that? You have two different players this time around, so I think it is much riskier.

Another thing to keep an eye on is a procedure in the House of Representatives to get something on the floor called a discharge petition. All it takes is maybe five, six moderate Republicans to join with the Democrats to file these petitions. They’re very, very complicated, and they take a lot of time.

Gilson:When do voters start paying attention to this issue — and what influence do they have?
Malhotra: Eventually, the real world has an impact. The history of these fiscal showdowns shows that, at some point, deals get done because regular voters start noticing things in their own life. When the markets start tanking, then people get scared, and they say, “Okay, we’ll just get the deal done.” And that’s on both sides.

When Will Investors Get Nervous About Default?
Gilson: How have bondholders reacted to previous debt ceiling showdowns? In 2011, did any investor really think that the U.S. government would default?
Arvind Krishnamurthy: The main issue that arose in 2011 was that bondholders were concerned that principal payment may be delayed on a one-month treasury bill until the debt ceiling issues resolve. So investors said to themselves, “I need a higher yield to compensate for that.” In 2011, you saw this effect: very short-term treasury yields rose. That was probably the clearest place where you could see that the markets were worried about our debt ceiling issues.

Delayed, not default — that’s what investors were thinking.

Gilson: What’s changed since that debt ceiling showdown?
Krishnamurthy: Compared with 2011, we are coming into this with a lot more government debt. I am less worried about the economic effects of any delay-induced dislocations in short-term treasury bills as we saw in 2011. I am more worried about risk-aversion-induced sales of longer-term government debt. If 5% of investors get a little nervous about a lot more government debt, that’s a lot more volume of trade that has to be absorbed in the system than when the debt was half or a third of what it is currently. The whole thing feels a bit more fragile.

Gilson: Could a debt ceiling standoff spark a larger financial crisis?
Krishnamurthy:During the COVID panic in March 2020, there were large sales of long-term treasury bonds to satisfy capital flow needs around the world. Treasury bond yields went up about 1% at the long end, which created a dislocation that had spillovers into the corporate bond market. The Fed stepped in and was able to resolve the dislocation.

There are more treasury bonds outstanding now than in 2020. It is within the range of possibilities that a debt ceiling standoff could trigger a larger dislocation. Will the Fed have the firepower or the willingness to step in again?

The treasury market is such an important market; it’s a central pricing market for many other securities around the world. Treasury securities also serve as collateral for a collection of financial transactions. Financial contagion effects could kick in when people get nervous about the underlying collateral.

We saw a version of this in the UK earlier this year when government bond yields spiked, leading to liquidity issues in pension funds, leading to further sales of government bonds, and pushing government bond yields up further. The UK can go through its bond market turmoil and have little impact on the U.S. But if the U.S. goes into turmoil, I guarantee that the UK — and the rest of the world — will be significantly affected.

Gilson: How could the market’s reaction influence the politics in Washington?
Krishnamurthy: The problem here is a making of politics. It’s not a making of the central bank or the financial markets. Certainly, if the politics result in a default on debt, we will have a financial crisis.

In 2011, you saw a small dislocation in the short-term debt markets, which was a signal that investors were getting a little nervous. I looked at short-term bond yields and right now, there’s little evidence of nervousness. The signals aren’t there. The fact that we’ve gone down this road before, in a sense, gives financial markets a feeling of, “Well, it’s worked out before. It’ll work out again.” So the market signals that this is worrisome don’t show up.

For the politics to react, the markets need to get worried. If everyone is convinced that it’s all going to be fine, then the financial market force never shows up. There’s an uncomfortable circularity at play right now.