Geopolitics and Markets Review - 16th January 2023:

Debt Ceiling Is Back – Bigger Is Better, Right?

The History:

We return to the scenario of the US reaching the self-created debt ceiling. Janet Yellen seems to pull this topic out of the wardrobe when she wants something to talk about. The debt ceiling details the limit on the amount of national debt that the US treasury can take on. The aim is to limit the interest the US pays on its debt.

In the past, we have always seen the debt ceiling raised. Not raising the debt ceiling would lead to the US not being able to pay its obligations, and hence potential default. The holder of the world’s reserve currency used in international trade, and most liquid currency in the world defaulting, on purpose. Not likely.

In the past, the US treasury needed to be authorized for a certain amount for whatever it was needed for. For example, in 1902, the Panama Canal Act was passed by congress and the US treasury was permitted to issue bonds to fund the construction.

This changed in 1917 in World War One. War finance completely shifts the priorities of the financial system. The strain on finance to manufacturing wartime technology is unprecedented in any other times, excluding pandemics. A podcast I listened to yesterday referred to the idea that the COVID-19 pandemic actually saw war finance embraced with high levels of money printing through debt issuance. And I can’t find many points to argue against this.

Congress passed a law that allowed the treasury to issue war bonds up to a fixed amount. This eventually became the debt limit on the treasury debt in July 1939. The debt limit was set at $45 billion. The amount of debt is decided by a budget surplus or deficit run by congress. This was raised annually until the end of the war when it sat at $300B.

Post-war saw the US government-run surpluses for three years and lowered the debt limit to $275B. Since this period, the debt ceiling has been raised to finance anything and everything.

The last changes to the debt limit occurred in December 2021 when it was raised by 2.5T up to 31.4T total debt. The Bipartisan Policy Center predicted this would help the federal government to pay its obligations through Q2 of 2023. Try 16 days into Q1 instead. The US is spending money quicker than expected. To review every change to the debt limit from 1940-2012, view this article from The Guardian.

Janet Yellen is the treasury secretary, and so explains why she urges those in power to deal with the debt ceiling. Can we see surpluses, the selling of bonds and a lower debt ceiling? Did anybody see the $1.7T bill passed last week? The US continues to spend, even as they try to reduce the government debt through quantitative tightening. It sounds like trying to clear water from a flood using your hands.

With no end in sight, bigger is certainly not better. The current geopolitical leader of the world is attempting to maintain geopolitical power through the dollar, and that can't be done with budget deficits. They can’t slide behind others and slow down innovation. This requires debt spending. Many analysts believe this is the time when the US will default on its debt obligations. The fastest interest rate hiking cycle ever, and the highest debt levels ever are contributing to this thesis. The key question is the term structure of this US debt. When does it have to make interest payments, and can it afford to for a sustained period? The weighted average duration of US government debt is over five years. So will we see problems emerge in 5-years on debt issued during these current periods of high-interest rates?

How much room does the Fed actually have to sell bonds, and lower the money supply through quantitative tightening? The Federal Reserve can only start to reduce assets from its own $9T balance sheet. A $95B-a-month strategy is being implemented. Reducing treasuries by $60B and mortgage-backed securities by $35B each month. Some analysts expect a $3T decrease in the Fed balance sheet over the next three years. This is unlikely. Once the lag effect of hiking interest rates is felt by the jobs market and reflected in the data, whether inflation is under control or not, they will have to cut rates and resume quantitative easing to incite growth in the US economy.

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The Present - US Government Deficit – Can It Be Turned Into A Surplus

As mentioned, in wanting to remain technologically relevant, the US has to maintain innovation. Innovation is maintained through education, a factor that typically drops off at the end of a geopolitical cycle. A geopolitical cycle is often sandwiched by war cycles. We are in a war cycle. The major physical war is in Ukraine, but we’ve seen infrastructure wars, cyber wars, trade wars, and many more will come.