Prior to 1917, Congress authorized the issuance of individual bonds to supplement tax revenues to finance specific expenditures. But after World War I, Congress authorized the U.S. Treasury to issue bonds as it saw fit, although it was limited by a debt ceiling. The legislative branch thus ceased to micromanage the issuance of Treasury bonds that finance spending (leaving that function to the executive branch) but retained its authority to ensure the distribution of powers by limiting the total amount of debt issuance, and must still authorize federal spending (source: Lyn Alden).

Raising the debt ceiling itself does not authorize new spending; it simply allows the government to continue to pay its previously authorized spending obligations. Not raising the debt ceiling means that the government must either: 1) not pay previously authorized spending obligations or; 2) default on its national debt, which has accumulated over time.

In other words, the idea of a budget constraint is relevant when deciding new spending and tax plans, but it is not relevant in debt ceiling disputes over past spending plans. 

Although originally designed to facilitate federal government borrowing, the ceiling has become a means for Congress to limit the growth of borrowing, making it a fiscal policy issue for the past few decades.

The U.S. government has come close to similar technical failures on several occasions since then. In 2011, the S&P Global Ratings agency cut the U.S. government's credit rating from AAA to AA+. To this day, the U.S. remains lower rated than some countries (notably Switzerland). 

In addition, when the debt ceiling is reached, the U.S. Treasury still has a few options. First, it has a primary cash balance that it holds at the Fed. They can reduce that balance to zero before they actually run out of money. They can also engage in inter-governmental borrowing, which means reshuffling the accounts. Another option is to invoke the 14th Amendment. 

When it runs out of options and reaches the threshold of available cash, the U.S. Treasury must then prioritize what it wants to continue to pay on time and what it is delaying or defaulting on. In this case, tax revenues would continue to be collected, but they would not be sufficient to cover current spending without a new issue of Treasury securities. With the debt ceiling legally preventing them from issuing new net Treasury debt, defaults on various bonds would begin to pile up.

Yellen plans to sell some investments and suspend reinvestments of some government funds that are included in the debt limit. These actions would reduce the amount of outstanding debt subject to the limit and continue to temporarily fund federal government operations.

For now, Mr. McCarthy is leaning towards spending cuts and has rejected calls from Democrats for an outright increase in the debt ceiling without any conditions. The White House has countered that it will not offer any concessions and will not negotiate an increase in the debt ceiling. In the meantime, House Republicans are preparing contingency plans that would tell the Treasury Department which payments to prioritize if elected officials fail to agree on the debt ceiling.

While we can expect heated debates in the coming months, we believe that a solution on the debt ceiling will be found, most likely at the last minute around July.

S&P 500 performance 1 month and 12 months after previous debt ceiling events (1995-1996, 2011, 2013)

Source: Edward Jones, Bloomberg

It is likely that if the U.S. government were to default on its debt obligations, significant market disruptions could occur, including a loss of confidence in U.S. bonds and the dollar, a sharp rise in yields, and an inability to perform essential functions such as maintaining national defense. From our perspective, the likelihood of such a scenario is extremely low.