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Economist Insights

Dancing on the ceiling

7 October 2013Asset management

The terms debt ceiling and debt limit are actually rather

misleading. They imply a restriction that stops borrowing

happening, but in fact simply refer to an enabling law

which allows borrowing to happen. Prior to 1917, when the

first debt limit was introduced, the US Treasury had to ask

permission for every Treasury note, T-bill or loan it needed to

issue. This was a laborious process, so a general permission

was introduced that enabled the Treasury to issue debt up to

a pre-set limit. It was a bit like granting the Treasury a limit

on its credit card rather than having to come back each time

revenues fell short of expenditures.

In short, the debt limit is not a way to control spending, but

rather a way to allow financing. Commentators often talk about

the fact that Congress has raised the debt ceiling 78 times since

1960 as if this shows that the limit was a failure because it did

not constrain debt. This is missing the point entirely.

Many outside the US, and even inside the country,overestimate how much power the US President has. It is

Congress that controls the purse strings: as the legislative

branch, Congress decides what taxes can be levied and what

expenditures can be made. The executive branch, headed

by the President, is then responsible for collecting the taxes

and spending the money as authorised by Congress budget.

When spending is higher than revenue, the Treasury needs

to borrow. For 2013, the Treasury has been instructed to

spend USD 3.5 trillion and revenues are expected at USD

2.8 trillion. This would mean borrowing of around USD 0.64

trillion (depending on how revenues come in). The existing

debt ceiling is too low to allow for that much borrowing.Since Congress has passed one law (the debt ceiling) that is

in direct contradiction with another law that it passed (the

budget or continuing resolution), the executive branch faces a

constitutional as well as practical dilemma.

Other countries avoid this problem by ignoring the whole

concept of a debt ceiling: since revenues and expenditure

are set by the budget then let the Treasury borrow as much

as is needed to balance the two. Denmark (alone in Europe)

has a debt ceiling but gets around it by setting the ceiling so

high that it would never make a difference. In 1975 Congress

introduced a sensible and logical approach by legislating that

the debt limit automatically increased in line with the budget.

In 1995 the Republican-controlled House of Representatives

voted to scrap that law and ever since then the debt ceiling

has become a political weapon.

If the debt ceiling is a weapon, then it is one that is liable to

explode in the users face. If the debt ceiling is not raised in

time, there is the possibility that the US could be forced into

a technical default technical because interest payments or

redemptions would be missed but investors still believe that

they would be repaid once Congress sorted the mess out.

Nonetheless, the financial and economic effects of even atechnical default could be devastating.

Ignoring for the moment all the high profile aspects of

finance such as mergers, share issuance and the like, the

less glamorous part of finance involves more mundane

borrowing and lending for short periods of time. You can

think of this as the plumbing of the financial system: not

very exciting but you really want it to work properly. Much

of that borrowing involves a borrower providing a security as

collateral for a loan, and much of that collateral is composed

of US Treasuries and T-bills. If these securities are called

into question by a technical default they may no longer beaccepted as collateral. To extend the analogy, there would no

longer be any water in the plumbing of the financial system.

The last time that this kind of systemic shock hit the financial

system was after Lehman Brothers collapsed five years ago.

Joshua McCallum

Senior Fixed Income Economist

UBS Global Asset Management

joshua.mccallum@ubs.com

Gianluca Moretti

Fixed Income Economist

UBS Global Asset Management

gianluca.moretti@ubs.com

The US Congress has passed one law (the debt ceiling) that is in

direct contradiction with another law (the budget or continuing

resolution) leaving the executive branch with a dilemma. If

Congress fails to extend the debt ceiling, it will force the Treasury

to either break the budget law by not spending what it is

meant to spend, or break the debt ceiling law and issue more

debt. Paradoxically, hitting the debt ceiling could be better in the

long run (if the debt ceiling is then challenged in the Supreme

Court) by removing the debt ceiling as a political weapon once

and for all. If the debt ceiling is raised, we know that Congress

will just be dancing with disaster again in the future.

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We are still experiencing the damaging impacts of that event

on the economy.

When the 17 October deadline is hit, will the US default on

its debt that day? Maybe, maybe not. The Treasury will have

USD 30 billion of cash on that day, and if revenues come in

like they did last year then there could be enough to cover

expenditures for a few more days. As far as Treasuries are

concerned, the first interest payment is on 31 October (see

chart). As long as the market is willing to roll over T-bills in

the interim then a default on government securities can be

delayed until the end of the month. Other payments would

stop earlier, including a sizeable social security payment due

on 23 October.

If Congress fails to extend the debt ceiling, it will force the

executive branch to break the law. The Treasury can either

break the budget law by not spending what it is meant to

spend, or it can break the law and issue more debt. What

are the options available to the executive branch and the

President as head of the executive?

Default on debt. As debt falls due the government would

hope to roll over the debt; for example, a maturing T-bill

could be repaid by issuing another T-bill. If this is not

possible, it may be forced to default. Even if debt is rolled

over, it could still default on interest payments.

Default on payments. In the course of its actions theFederal government builds up obligations: employees must

be paid at the end of the month, invoices for goods supplied

and services rendered are due a certain number of days after

they are delivered. By falling late on these payments the

Treasury can free up some cash flow, at least in the short

run. This would still be a type of default and would be very

painful for the employees and companies involved, but has

the advantage that it would not be a systemic shock.

Cut spending. Much like the government shutdown,

the government could choose to cut spending. But this is

austerity by accident and eventually the effects would add up

to a further tightening of over 4% of GDP over the year. That

would spell deep recession.

Capitulate. The Democrats could grant enough concessions

to the Republicans to convince them to raise the debt ceiling.

This may keep the markets happy for now, but it will just

encourage politicians to keep using the debt ceiling as a

weapon again and again. Ironically, it would make the US a

riskier credit.

Constitutional approach. Hitting the debt ceiling

would not only force the executive to break at least one

Congressional law, but it could also break Constitutional

law. The fourteenth amendment to the Constitution requires

that the validity of the governments debts shall not becalled into question. This does not just mean Treasuries;

defaulting on salaries of employees or monies owed to

suppliers would also qualify as a debt. This suggests that

the only course open to the executive is to ignore the debt

ceiling, keep issuing debt and ask the Supreme Court to

rule that the debt ceiling would breach the Constitution. For

some unfathomable reason President Obama ruled out this

approach at the last debt ceiling impasse in 2011.

Game theory suggests it would be irrational for the

Republicans to force a shutdown, and if the Constitutional

approach is legitimate then it would be irrational for the

Democrats to offer any concessions. Clearly some in the

Republican party might be willing to let the debt ceiling

be hit, but rumours are already circulating that the more

moderate Republicans would be willing to join Democrats for

a vote to raise the debt ceiling.

Paradoxically, hitting the debt ceiling could be better in

the long run, provided that the Constitutional approach is

taken and the Supreme Court rules that the debt ceiling is

not binding (only the Budget is binding). This would remove

the debt ceiling as a political weapon once and for all and

actually improve the creditworthiness of the US. In contrast,

if the debt ceiling is raised, or even worse raised for only afew months, we know that Congress will be dancing with

disaster again and again. Eventually that could make investors

question whether the US dollar really deserves to be used as

the worlds reserve currency.

The views expressed are as of October 2013 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended forlimited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publicationwithout the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is acceptedfor any errors or omissions herein. Please note that past per formance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value ofinvestments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication.Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdictiondesigned to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The

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Ceiling caving in

Scenario for US cumulative daily expenditure and revenue flows

Source: CBO, Treasury Department, UBS Global Asset Management

Note: Revenues are assumed to be the same as for the same dates last year, scaled up

by the increase in revenues over the last 12 months relative to the prior 12 months

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