How Companies Should Prepare for Repeated Debt-Ceiling Standoffs

Summary.    Since a major realignment of the U.S.’s two-party political system is unlikely, we can expect partisan conflict and the subsequent debt-ceiling standoffs to continue for the foreseeable future. Corporate managers must not regard debt-ceiling crises as just...

On August 1, Fitch, one of the three major credit rating agencies, downgraded the U.S. credit rating amid yet another debt-limit standoff, removing the U.S. government from the list of risk-free borrowers. In doing so, it made good on the warning it issued during the last debt-limit fight in May 2023, when it put the U.S.’s AAA rating on negative watch. Even S&P, another of the major credit rating agencies, warned at that time: “The last-minute negotiated compromise is likely, but…the risk of a technical default has increased.” Fitch clarified the reasoning for its August 1 downgrade in a statement: “[The] repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management.” The ensuing rout in global financial markets once again shone a spotlight on the U.S.’s repeated debt-ceiling crises.

Why should corporate managers care about the debt ceiling? It’s beholden to political battles and theatrics, which may seem farcical to an outsider, but increasingly reflects the growing polarization of the U.S.’s two-party political system. Managers must plan for the drama that plays out almost every year and could one day even result in a fiscal collapse. While the debt ceiling may seem like a purely political matter, managers must understand the dynamics of these standoffs and account for them in their operational strategies and long-term planning.

Why Debt-Ceiling Standoffs Keep Happening

The U.S. government’s debt-to-GDP ratio jumped from about 60% in 2008 to above 100% in 2019. But the U.S. government isn’t alone when it comes to growing indebtedness. Japan, for example, went from a debt-to-GDP ratio of 132% in 2007 to 198% in 2019. Covid worsened this trend, growing the U.S.’s debt-to-GDP ratio beyond 120% in 2022. Similar trends were observed for virtually every developed economy, as governments gave stimulus payments and implemented other fiscal and monetary stimuli to counteract the effects of the pandemic.

Nevertheless, the debt ceiling makes the U.S. peculiar in terms of how it manages indebtedness. That distinction frequently brings the government to its knees — Congress has raised the debt ceiling 45 times in the last 40 years. Fitch mentioned this in its latest rating downgrade: “In addition, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process.”

The debt ceiling refers to the total debt the federal government is allowed to accumulate. Before 1917, Treasury had to get congressional approval to issue every bond or take on any other debt. With the Second Liberty Bond Act of 1917, Congress created the debt ceiling, which allowed the Treasury to issue bonds and take on other debt without specific congressional approval as long as the total debt fell under the statutory debt ceiling.

Decisions about aggregate debt ultimately fall to the legislative branch. The ceiling imposes limits on the scope of fiscal policies and the functioning of the executive branch. Conceptually, the separation of authority between the legislative and executive branches should impose important checks and balances. The fact that approval is not automatic should, in theory, lead to healthy debate and consequently improve social welfare. In such a scenario, nobody should fear that the richest and most advanced nation would even come close to debt default.

It’s inevitable that the aggregate debt limit would need to be raised frequently. In normal course, the government must borrow to meet its existing legal obligations like Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. Medicare, Medicaid, and Social Security currently account for 63% of federal spending. Given an aging population, health care and retirement programs, and simple inflation, growing expenditures are beyond any single party’s control. Even so-called discretionary spending is largely in areas such as defense, research, and education, whose direction cannot be entirely changed by a single party.

Differences then arise on peripheral issues, which are related to political rhetoric. For example, the 2013 standoff took place because Republicans wanted President Obama to eliminate the funding for the Affordable Care Act. And in 2019, President Donald Trump said he wouldn’t budge on the debt limit until the Democrats approved $5.7 billion for the wall he wanted along the U.S.-Mexico border.

In this era of growing partisan conflict, such standoffs are becoming increasingly frequent, tortuous problems that combine political brinkmanship and the potential for catastrophic consequences. Shutdowns not only affect the government’s functioning, they seriously damage the country’s reputation.

Why Corporate Managers Should Care About the Debt Ceiling

Corporate managers can no longer consider the debt ceiling just a political issue. They must be aware of the two types of events that will be repeated on an almost annual basis, as well as their consequences for their business.

The first is a temporary event, like the 2019 standoff that affected 800,000 federal workers, temporarily slowing down the government machinery.

The second is an actual default on U.S. debt obligations, which could leave a more permanent, catastrophic mark. In May 2023, White House economists said a protracted default would wipe out more than 8 million jobs and cut the value of the stock market in half.

Since a major realignment of the U.S.’s two-party political system is unlikely, we can expect partisan conflict and the subsequent debt-ceiling standoffs to continue for the foreseeable future. Here’s how corporate managers can plan for and weather these crises:

Pay attention to timing …

The direct consequence of increased polarization is that uncertainty peaks predictably in phase with presidential and mid-term election cycles. In addition, the dynamics of the debt ceiling — the path of the U.S.’s government’s debt and its projections about reaching the ceiling — can create additional peaks of uncertainty.

Thus, first and foremost, managers must be aware of the expected timing of such peaks of uncertainty in the macroeconomic environment.

… and trends.

Second, managers must watch out for trends in partisan conflict, polarization, and alignment between the executive and legislative branches. The degree of disagreement between the major parties in the U.S. can now be gauged beyond anecdotal examples — it is systematically measured. For example, the Partisan Conflict Index, created by the Federal Reserve Bank of Philadelphia, tracks the degree of political disagreement among U.S. politicians at the federal level, almost on a real-time basis. Managers can better anticipate periods of elevated fiscal policy uncertainty and prepare for the consequences.

Analyze.

Third, managers must conduct a thorough, firm-specific, scenario-based analysis along the following dimensions:

Understand how fiscal policy uncertainties affect their business operations. The prospects of government shutdowns and the odds of more catastrophic scenarios of U.S. debt default have systematic consequences for the entire global economy. However, not every firm is affected by such risks equally.

Plan precautionary cash. A fiscally constrained government has a range of activities compromised, from the provision of basic public services to tax collection and enforcement. Firms that rely on government contracts or that serve customers who directly rely on government stimuli are far more subject to debt-ceiling stalemates. Imagine the impact on the airline industry if air traffic controllers, immigration officers, and TSA workers didn’t show up for work. Managers must plan precautionary cash as a cushion to ride out such difficult times and must line up assured lines of credit.

Evaluate dependence on government policies. Each compromise has the potential to change government policies related to taxation and duties, import restrictions, government subsidies, mining rights, and resource availability. Managers must evaluate their dependence on such policies in terms of how they affect profitability, growth prospects, and uncertainty in their business.

Study the specific details of each resolution of the debt-ceiling crisis. Agreements between the executive and legislative branches regarding the debt ceiling are not created equal. Such agreements entail a complicated compromise of policy stances, each of which has different implications for different corporations.

Understand how political cycles affect equity valuation and cost of capital. It’s well known that uncertainty affects security prices and expected returns. However, the effect is not homogeneous across business models. Moreover, different businesses are subject to the economic approval of the president in different ways — there’s even an index tracking it.

A deep understanding of how firms’ cost of equity and debt are affected by political tensions help managers better define their capital structure in anticipation of such crises.

Fine-tune the selection of senior managers and board members. Those who can manage in times of crisis aren’t necessarily the same as those who can manage during tranquil times. Given that it’s impossible to quickly change managers in response to changes in political uncertainty, you need an optimal mix of both types of skills and managers.

Seize opportunities. In times of elevated uncertainty, across-the-board cuts in hiring and capital expenditures may be tempting, but that may not be the best long-term move. Uncertain times during standoffs may also be the most opportune times to attract customers and workers from the competition — for example, experienced workers in government agencies who are fed up with furloughs and forced work without pay.

Invest in real options. Uncertainty increases the value of certain projects that initially require relatively small investments in R&D, experiments, and pilot projects. These projects are usually likely to fail but can have big, lottery-type payoffs if successful — think patents, a first-mover advantage in a particular area, or the discovery of a new medicine. Studies show that firms increase their R&D in years with high uncertainty over government policy in election years. Thus, managers working in areas like biotechnology, electric vehicles, wind energy, carbon capture, artificial intelligence, and oil exploration should consider planting the seeds for projects that can pay off big when the government policies become clearer.

Corporate managers must not regard debt-ceiling crises as just political gimmicks, as they repeatedly and predictably affect firm profitability, growth prospects, and uncertainty. Managers must proactively gather information, anticipate, plan, and allocate resources in preparation of each crisis. They must be able to capitalize on opportunities that arise from each standoff and be prepared to weather each storm.