Not raising the debt ceiling could cause another sell-off in the stock market. If so, history has shown it is worth buying the dip as politicians eventually agree to raise the debt ceiling limit and curb some spending.
However, have you ever wondered why the government doesn’t spend more responsibly? After all, we individuals are tasked to budget and spend within our means. Why shouldn’t the government as well?
If we individuals continue to spend far beyond what we earn and can comfortably afford, we’ll ruin our credit, get our assets confiscated, and be shunned from society. Nobody will trust us if we consistently can’t pay back our debt.
Let’s explore this double standard regarding fiscal responsibility!
Why The Government Doesn’t Spend More Responsibly
The concept of “spending within your means” for a government is different from that of an individual or a household. Governments have the ability to issue debt and borrow money to finance their spending. Individual households largely do not.
Here are a few reasons why governments may not always spend strictly within their means:
1) Desire To Stimulate The Economy
During economic downturns, governments may engage in deficit spending to stimulate economic activity and mitigate the negative impacts of recessions. By increasing government spending, they can create jobs, support businesses, and provide social safety nets. This approach aims to boost economic growth and eventually increase government revenues.
For example, during the heart of the pandemic, the government spent trillions of dollars to support and stimulate the economy from devastation. Programs such as PPP loans and student loan forbearance helped keep small businesses and college graduates afloat.
2) Creation And Maintenance Of Social Programs and Safety Nets
Governments provide social programs, such as healthcare, welfare, and unemployment benefits, to support their citizens. These programs are aimed at promoting social welfare and reducing inequality. Fulfilling these commitments often requires government spending that may exceed current revenue.
During the 2008 global financial crisis, the federal government famously provided 99 weeks of extended unemployment benefits. As a result, the term “funemployed” was formed to label those who collected unemployment benefits while traveling and having fun for almost two years.
When the federal government offers extended unemployment benefits beyond the standard 26 weeks offered by the state government, the value of a severance package goes way up. After all, if you are able to engineer your layoff, you can collect all the unemployment benefits you want.
If you quit your job, you are usually ineligible for collecting unemployment benefits. Why? Because you quit, which the government and your employer presumes means you don’t need the money. An employer can accept or contest the unemployment insurance claim.
3) Public Investments For The Greater Good
Governments often invest in infrastructure, education, healthcare, and other areas to promote long-term economic development and societal well-being. A lot of the time these types of projects require borrowing to cover the upfront costs. In large urban areas, it’s not uncommon to see projects that run in the multi-millions.
Such spending is portrayed as an investment in a locale’s future and is may be considered justifiable even if it leads to temporary deficits. The problem lies with running up a large deficit, which leads to future generations getting saddled with debt and higher interest payments.
If you don’t have children, you may be more amenable to the government spending beyond its means. Constantly raising the debt ceiling is a logical act to cover inflation and a growing economy.
However, unless you have generational wealth, perhaps you will feel more stress and anxiety for your children who will have to shoulder more debt. In general, most people want to leave the world a better place for future generations, not worse.
4) Revenue Volatility
Government revenues are subject to economic fluctuations, which can affect their ability to balance budgets without borrowing.
During economic downturns, tax revenues may decline while government expenditures for social safety nets increase. This can also result in budget deficits that need to be covered through borrowing.
For example, many office buildings are at lower occupancy levels than before the pandemic. As a result, there is less economic activity in business districts, resulting in a negative loop of fewer home sales, fewer restaurants, fewer conferences, and more.
The desire for lower revenue volatility is one of the reasons why local governments make you fight to get your property taxes lowered, even though property prices are coming down.
Political Priorities and Trade-Offs
During election years, politicians will often pander to the public to gain the most amount of votes. Therefore, fiscal discipline sometimes gets thrown out the window. The more free money you can promise people, the more support you will likely gain.
If politicians don’t meet the needs and demands of their constituents, they won’t be politicians for much longer. Public policy objectives also influence the allocation of resources. Different priorities and trade-offs can thus lead to deficits and debt accumulation.
How Much Could The Stock Market Crash If The Debt Ceiling Isn’t Raised?
Based on history, the maximum S&P 500 decline during the 2011 debt ceiling debate was -19.4%. In 2013, the S&P 500 declined by -5.8%.
Hence, we can assume that if the current debt ceiling issue doesn’t get resolved quickly, the stock market could also decline by a similar magnitude or more.
2023 stock market valuations are in the top 15% of historical averages while aggressive rate hikes are slowing down economic activity. As I wrote in my post, How I’d Invest $1 Million Today, I’m not a fan of buying the S&P 500 at the ~4,200 level.
Sure, there could be a nice relief rally when the debt ceiling debate is resolved. But fundamentally speaking, the stock market isn’t a table-pounding buy at the moment.
Ironically, I’d much rather lend the government money in the form of Treasuries, yielding higher yields due to the debt ceiling issue. In addition, I prefer buying real estate as a catchup play to the stock market.
Variables Affecting The Magnitude Of A Stock Market Correction
The failure to raise the debt ceiling and its effect on the stock market depends on several variables. Here are a three main points to consider.
1) Government Shutdown
Failure to raise the debt ceiling can result in a government shutdown, leading to a disruption in various sectors of the economy. A prolonged shutdown can have negative impacts on businesses, consumer spending, and investor sentiment, potentially affecting stock market performance.
For many in the private sector or who are proponents of smaller government, a prolonged shutdown may be welcome.
In 2020, when the government forced to shutdown small businesses, members of congress and other federal government employees were able to keep earning their full salaries and benefits. This double-standard infuriated many business owners and employees who had no other choice but to close.
A long government may fore politicians to spend future dollars more carefully. It may also help politicians empathize more with common people who don’t have pensions, access to insider trading, and bulletproof incomes.
2) Policy Response
The response of policymakers, including the government and central banks, to a debt ceiling impasse can influence market reactions. If appropriate measures are taken to address the situation and restore confidence, it may help mitigate the negative impact on the stock market.
A strong response to COVID-19 helped the economy and stock market rebound quickly in 2020. If the Federal Reserve decides to pump more liquidity into the system again when markets are crashing, like it did when regional banks failed, perhaps the stock market won’t sell off so bad.
3) Contagion Possibility
The failure to raise the debt ceiling can have broader implications for financial markets beyond the stock market. It may impact the bond market, interest rates, credit ratings, and overall financial stability.
In addition, the debt ceiling issue could cause debt ceiling fears in other countries. If there is a global crisis of confidence, all types of risk assets could sell off hard.
The Importance Of Sustainable Fiscal Policy
Maintaining a sustainable fiscal policy is essential for long-term economic stability. Excessive deficits and mounting debt can pose risks to the economy, leading to concerns about inflation, a weakened dollar, damage to U.S. creditworthiness and reputation, and limited fiscal flexibility.
Foreign investors in U.S. debt will require a higher interest rate to account for greater risk of non-payment or delayed payments. As a result, economic activity could slow even further, creating a negative economic loop.
Achieving a balance between spending priorities, revenue generation, and managing debt is a challenge that requires careful consideration of economic conditions and long-term sustainability. Given the United States has a democratic system, resolving the debt debacle can be messy.
Personally, I want the debt ceiling raised with some future spending cuts for more fiscal discipline. As an investor in risk assets, I don’t want the stock market or other asset classes to crash.
I depend on the normal functioning of government and credit markets to sustain and grow our economy. You should ultimately want the debt ceiling to be raised as well.
However, for those of you waiting on the sidelines with a lot of cash or are just starting on your financial journey, a lack of resolution in the debt ceiling may be exactly what you want. You might be able to buy assets for cheap until politicians no longer want to play chicken with our livelihoods.
Fiscal Responsibility In Households
Despite the government displaying a case of “do as I say, not as I do,” we should all continue to demonstrate fiscal responsibility. Don’t expect the government to save you financially given it can hardly manage its own finances properly.
If you want to achieve financial freedom, don’t stop saving and investing. Continue to spend less than you earn. If you don’t, you might get into a lifetime of debt with no way out.
Reader Questions and Suggestions
What do you think of the debt ceiling debate? How do we decide how much to raise and why? Does the United States government spending beyond its means really matter if the government can just print money? Will future generations really pay the price if the government just continues to spend beyond its means?
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