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Client Questions | February 13, 2023
The federal debt is simply the amount of money that the United States federal government has previously borrowed and subsequently owes. When spending exceeds revenue, the government is running a deficit. When the government incurs a budget deficit, the Treasury sells securities and uses the proceeds to fill the gap between revenue and expenses. Essentially the federal debt is the total accumulation of historical deficits. Please see our Client Question on The Federal Debt.
When the government borrows money, the Treasury Department sells securities to investors in the form of bills, notes, and bonds. Treasury securities (“Treasuries”) are backed by the full faith and credit of the United States, which means their principal and interest payments are effectively assured by the government. Treasuries are offered in a wide range of maturities, are exempt from state and local taxes, and are usually very liquid.
The debt ceiling is the limit that the federal government is authorized to borrow to fulfil its obligations through the issuance of US Treasury securities. Once the debt ceiling is reached, the Treasury cannot issue new debt until Congress votes to raise or suspend the limit. This creates an obvious problem when the government is running a deficit and the Treasury cannot sell securities to close the gap between revenue and expenses.
According to the Constitution, Congress must authorize borrowing. The debt ceiling was created in 1917, to make it easier for the United States to finance World War I. Congress provided the Treasury with an aggregate debt limit so that each bond did not have to be approved separately.
The US Treasury Department notes that since 1960, Congress has raised, extended, or revised the debt limit 78 times. Congressional action to alter the debt ceiling has occurred 49 times under Republican presidents and 29 times under Democratic presidents.
The most well-known debt ceiling fight came in 2011, when Standard & Poor’s (S&P) downgraded the United States debt rating from AAA (outstanding) to AA+ (excellent) on August 5th. The downgrade took place soon after Congress signed the Budget Control Act of 2011 that ended the preceding debt ceiling battle. According to the Government Accountability Office, the downgrade increased the Treasury’s borrowing costs by about $1.3 billion in that fiscal year.
The debt ceiling was raised most recently on December 15, 2021, when Congress approved an increase of $2.5 trillion to place the debt limit at its present level of $31.381 trillion. The United States debt level keeps rising because the government continues to run a budget deficit. The Congressional Budget Office (CBO) estimates the budget deficit was over $1 billion in 2022 and will average $1.2 billion over the next five years.
Treasury Secretary Janet Yellen sent a letter to Congress earlier this year to announce that the United States would reach the debt limit on January 19, 2023. At that point, the Treasury started to undertake extraordinary measures to prevent a default. According to the Secretary Yellen, the department’s actions will “reduce the amount of outstanding debt subject to the limit and temporarily provide additional capacity for Treasury to continue financing the operations of the federal government.”
Treasury Secretary Yellen warned that the extraordinary measures will be exhausted before early June.
To no one’s surprise, Congress is still deadlocked over the debt ceiling with Democrats and Republicans disagreeing over how it should be raised. Historically, the arguments made by Democrats and Republicans for-or-against raising the debt ceiling flip depending on which party is in control. Democrats argue that raising the debt ceiling allows the government to financing existing obligations that were already approved by Congress. Republicans argue that future government spending and deficits should be curtailed.
President Joe Biden met with House Speaker Kevin McCarthy to discuss the debt ceiling in early February. President Biden has stated that the White House will discuss federal spending, but only after the debt ceiling is raised. While Speaker McCarthy’s position is that Republicans will agree to raise the debt ceiling after the two sides agree on spending cuts. We’ll take this as a positive sign that the two sides are talking this early.
While both a government shutdown and default both affect the ability of the government to function, they are two separate issues.
• Government Shutdown: Many federal government agencies rely on annual funding appropriations passed each year by Congress. A shutdown occurs when Congress does not pass the appropriations bills, typically leading to the temporary closure of non-essential agencies and furloughs for some government employees. Past shutdowns have temporarily halted Social Security and Medicare benefit verification, Environmental Protection Agency (EPA) site inspections, tourism at national parks, air traffic controller responsibilities, and Internal Revenue Service (IRS) functions. According to the Committee for a Responsible Budget, there have been four government shutdowns where operations were affected for more than one day (1995, 1996, 2013, and 2018).
• Default: A default would occur if the government has exceeded the debt limit and does not have enough money to pay its obligations, including, Social Security and Medicare benefits, military salaries, and payments to bondholders. In past government shutdowns, the government continued to make regular payments to retirees and bondholders. A default has far greater consequences than a shutdown.
Simply put, a United States government default would be a self-inflicted disaster. Treasury Secretary Janet Yellen stated that a default “would have catastrophic economic consequences. The full faith and credit of the United States would be impaired, and our country would likely face a financial crisis and economic recession.” Here are just a few nightmarish things that may happen if the US defaults:
End of the risk-free rate: United States Treasury securities are viewed as “risk-free” because their principal and interest payments are effectively assured by the government. The concept of the risk-free rate serves as a foundational component for all of finance; it is the basis to value all other assets. For example, most securities are valued as the risk-free rate plus an amount to compensate for the danger of potentially losing money on the investment. As the investment gets riskier, the investor will demand a greater spread over the risk-free rate. If the risk-free rate suddenly faces default risk, all of finance will be turned upside down.
Another US Debt Downgrade: Standard & Poor’s (S&P) previously warned that a default on a single US Treasury security would drop the United States credit rating from AA+ to D, the lowest level. S&P stated that, “it would be unprecedented in modern times for an advanced G-7 country, like the United States, to default on its sovereign debt.”
Higher borrowing costs: Borrowing costs will likely increase for corporations, individuals, and homebuyers if people sell their Treasury holdings and thereby push up interest rates. The interest rate will rise for any debt instrument that uses Treasuries as a reference.
End of the dollar as the world’s reserve currency: In 1944 the US dollar became the world’s reserve currency when 44 nations agreed to create the International Monetary Fund (IMF) and the World Bank. The arrangement became known as the Bretton Woods Agreement and decided that the world’s currencies would be pegged to the US dollar instead of gold. According to the IMF, 59% of the central banks held their reserves in US dollars by the fourth quarter of 2021. If the US were to default, other countries would probably not feel comfortable holding their reserves in dollars.
While this list is frightening, it is not comprehensive. A US default would likely have many other negative consequences and knock-on effects.
The debt ceiling is mostly political theatre. Since a default would be disastrous, most expect Congress to ultimately reach an agreement. In our view, it is very unlikely the United States will ever breach the debt limit and default. Politicians know that neither Democrats nor Republicans would “win” the event and that both sides would rightfully receive blame. The worst-case scenario we can imagine is that the debt ceiling is breached for a short-time period before the public outrage forces Congress to quickly reach an agreement (this would be national embarrassment but might not cause great economic damage). The unlikely event of a default is why the markets do not react much to the debt ceiling deadline anymore. Unfortunately, we all still have to watch the bad theatre and political grandstanding for the next few months before Congress likely addresses the issue at the last minute.
No matter what the two sides say between now and June, the odds strongly favor a resolution before the deadline. Of course, we will monitor the situation closely and we will continue to apply our time-tested investment process based on risk management, asset allocation, and security selection to utilize any volatility as an opportunity to reposition portfolios.
At Winthrop Wealth, we apply a Total Net Worth Approach to both comprehensive financial planning and investment management. We believe financial planning drives the investment strategy and provides a roadmap to each client’s unique goals and objectives. The comprehensive financial plan defines cash flow needs, is stress tested for various market environments, seeks to optimize account structures, considers tax mitigation strategies, and continuously evaluates financial risks as circumstances and/or goals change. The investment management process is designed to provide well-diversified portfolios constructed with a methodology based on prudent risk management, asset allocation, and security selection. Investors are reminded that no strategy assures success or guarantees against loss.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Financial planning is a tool intended to review your current financial situation, investment objectives and goals, and suggest potential planning ideas and concepts that may be of benefit. There is no guarantee that financial planning will help you reach your goals.
Past performance is no guarantee of future results.
Asset allocation does not ensure a profit or protect against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.
Diversification does not protect against market risk. All investing involves risk which you should be prepared to bear.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Winthrop Wealth, a Registered Investment Advisor and separate entity from LPL Financial.