The debt ceiling has been in the news often lately, and not for good reasons. Despite the United States reaching the debt ceiling in January 2023, partisan deadlock in the federal government has stopped Congress from increasing the limit. 

So far, the Treasury has been able to rely on extraordinary measures to keep the government afloat, but those aren’t long-term solutions. Those measures are expected to be exhausted in the summer of 2023, which could have major financial implications for the country, Wall Street, and you as an investor. 

The history of the debt ceiling 

The debt ceiling was created in 1917 through the Second Liberty Bond Act. This limit serves as a cap on the amount of debt the federal government can accrue. The limit has been increased many times over the years — more than 100 since World War II — to allow the government to continue to meet its spending obligations.i 

“Once the limit is hit, it is Congress who must approve an increase in the limit so that the government is able to issue more debt – for example, through the sale of bonds – to finance outstanding obligations,” said Lacey Cobb, Director of Advice Solutions and Portfolio Management for Empower. 

Raising the debt ceiling is necessary to allow the federal government and the economy to continue to function as they need to. And historically, Congress has always raised it when necessary. But it’s also become increasingly political in recent decades. 

Where the ceiling stands today 

The most recent debt ceiling increase happened in December 2021 when Congress raised it to $31.4 trillion. Just over one year later, on January 19, 2023, the federal government reached the debt limit. However, as of the end of March 2023, Congress hasn’t raised it. 

As the government approached the debt ceiling, Treasury Secretary Yellen announced the department could use extraordinary measures to allow the government to continue to meet its obligations, but those measures would only last so long.  

According to Congressional Budget Office (CBO) projections, they’ll be exhausted between July and September of 2023 (or earlier, depending on whether the government’s tax revenue was less than expected.

But as of the end of mid-April 2023, Congress appears to have made little progress toward increasing the debt ceiling. The House and Senate must both sign off on an increase to the debt ceiling. And with a divided government, there’s been little cooperation or progress. 

What happens if the U.S. hits the debt ceiling? 

Given the public debate over the debt ceiling and the clear lack of cooperation between the parties involved, many people are naturally worried about the consequences if Congress doesn’t raise the limit. 

To explain what happens if the U.S. hits the debt ceiling and exhausts its extraordinary measures, it might be helpful first to explain what raising the debt ceiling really does. Raising the debt limit doesn’t authorize new spending. Instead, it simply allows the government to meet the financial obligations already laid out by Congress. 

The government’s financial obligations include critical programs and services such as Social Security and Medicare. However, they also include servicing the debt we already have as a country. And because the government’s annual spending exceeds its tax revenues, it wouldn't be able to continue meeting those obligations without debt. 

If Congress fails to raise the debt limit, two things are likely to happen. First, the federal government may not be able to meet all of its spending promises. Retirees may not receive their Social Security benefits. Federal employees may not receive their paychecks. Ultimately, the federal government makes more than 80 million payments each month. Some of those payments would be prioritized, while others would not. 

Additionally, there could be dire consequences if the government fails to make its current debt payments. If you simply stopped paying on one of your loans, it would go into default. Government debt is no different, and without an increase in the debt ceiling, the government could default on its debt. 

The U.S. defaulting on its debt could have major consequences. For example, it would likely affect the country’s credit rating. 

“Credit ratings influence borrowing costs and are used by both institutional and individual investors to gauge creditworthiness,” Cobb said. “The lower the credit rating, the higher the cost to borrow.” 

And just as your credit score going down could cause creditors to lose trust in you, the U.S. having its credit rating dropped would cause creditors to lose trust in the government. 

“The most extreme example was 2011 when Standard & Poor’s issued the first-ever downgrade of the U.S. government’s credit rating as the final hours of the deadline loomed, and still no deal had been reached,” Cobb said. “In the end, a deal was still reached in time to avoid default. However, this still created significant market volatility, and it was a huge hit at (least short-term) to consumer confidence. 

If the U.S. were to default on its debt, the implications could be far larger than just a creditor not getting paid. Instead, it could result in a major downturn in both the U.S. and domestic markets. According to a 2021 Moody’s Analytics report, the effect on GDP and unemployment could reach levels similar to the Great Recession.iii 

Finally, remember that the federal government’s debt isn’t all held by big banks as the average person’s might be. The government’s creditors include state and local governments, companies, individual investors, and more.  

If you own Treasury securities, you’re a creditor of the U.S. government. And while those investments have previously been nearly risk-free, since they are backed by the federal government, a default could result in individual investors losing money. 

Given the dire situation that could result in a failure on Congress’s part to raise the debt ceiling, many experts say it isn’t likely to happen. 

“The U.S. has never defaulted on its debt and for good reason,” Cobb said. “There are recent historical examples of similar situations to look back on and a deal was ultimately reached – we don’t expect this time to be different.  

“It would not be in anyone’s best interest to let this happen because the repercussions could be catastrophic and therefore it's well understood it must be avoided.” 

What investors can do to prepare 

The U.S. hitting the debt ceiling and defaulting on its debt would have implications that expand far beyond just the U.S. government. It would also affect the entire U.S. economy — and likely the world economy. And, of course, that means individual investors are likely to feel it in their portfolios as well. 

According to Cobb, investors shouldn’t necessarily change their investing strategy in anticipation of the U.S. defaulting on its debt. 

“Generally, it usually does not make sense to position portfolios for worst-case scenarios,” Cobb said. “These tend to be events that have a very low likelihood of happening, so the most likely outcome is the portfolio underperforms. A portfolio positioned for a single outcome also means it would be heavily exposed to other types of risks because it would not be diversified.” 

Instead, Cobb recommends the same investing strategy she would in other scenarios. In other words, build a well-diversified portfolio that includes multiple asset classes and geographic regions. History has shown that this type of portfolio is more likely to weather market volatility, no matter what the cause. 

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