The coming debt limit fight in Congress was always going to be challenging, but the results of this week's midterm elections could make the dispute even more contentious.
After a so-called red wave failed to materialize, Republicans will likely control the House of Representatives next year — but only by slim margins. Their speaker will have to work with a more influential right-wing that includes 180 recently elected members who question the 2020 election results, are loath to compromise with Democrats, and have pledged to use the debt limit to keep the Biden administration in check.
That dynamic, paired with a Senate remains up for grabs, is igniting concerns in Washington and on Wall Street that even more brinkmanship could be in store than previously expected.
"The risk of a debt ceiling crisis has gone up meaningfully because of the somewhat surprising outcome of the midterms," says Charles Myers, founder of Signum Global Advisors, contending that a more decisive victory for Republicans might have defused the tension a bit.
If Congress doesn't raise the debt ceiling, the U.S. could default on its obligations — a development that would have unpredictable consequences for the U.S. and global economy. History proved in 2011 that even a close proximity to a government default can upend markets, damage the U.S. credit rating, and sink stocks.
Some analysts say a divided government benefits markets; they contend a polarized Congress won't pass new industry regulations or introduce uncertainty for business. Myers doesn't think that feuding lawmakers will help the stock market in 2023, though.
“A lot of historical patterns or other frameworks actually don't really apply," he said, "and I think what we'll probably find out next year is gridlock was not good."
The chances of solving the problem in the ‘lame duck’
Congress has one potent option to end the standoff before it even begins: it could pass a bill in the so-called "lame duck" session before Jan. 1 to either raise the debt ceiling or even abolish it before new lawmakers take office. But that's a slim possibility, experts told Yahoo Finance this week.
Myers projects a 75% chance of a debt ceiling crisis next year, versus a 25% chance it’s solved by current lawmakers. The Bipartisan Policy Center in Washington monitors the debt ceiling closely and its director of economic policy, Shai Akabas, agrees with those odds.
“It seems like it's fairly unlikely that they will reach a deal on this in the lame duck,” he said in an interview this week. “If we look at recent history, it is likely to be another messy fight."
Meanwhile, conservative members of Congress known as the Freedom Caucus gathered in Washington this week to assert their influence within the Republican Party. The members of this group are urging their Republican colleagues in Congress to exploit the debt ceiling fight to force spending cuts.
Kevin Brady, outgoing ranking member of the House Ways and Means committee, doesn't belong to the Freedom Caucus but predicted that government spending will be a part of the debt ceiling talks.
“I do expect a conversation about how America and how Congress addresses our financial footing for the long term,” he said this week.
‘A lot of trouble and chaos’
To complicate matters, experts say it's tough to predict the coming date of default. First, the U.S. has to breach the debt limit. The Treasury Department then deploys “extraordinary measures” to move money around and delay the crisis. But that financial jujitsu can't last forever, and at some point the U.S. won't be able to pay its bills. That's called the X date.
In June, the Bipartisan Policy Center projected the X date could fall in July 2023, but inflation, rising interest rates and other economic headwinds have increased the possibility that the day could move up in the second quarter of 2023.
In the meantime, Lee Drutman, a senior fellow at New America, predicts Republicans and Democrats will hold firm in their debt ceiling positions: “There's going to be a whole game of chicken here."
The dilemma for possible House Speaker Kevin McCarthy, Drutman adds, is "essentially if he backs down on this fight, there's some group in the Republican Party who will probably try to overthrow him as Speaker.” Even if they fail, Drutman said, the group may be able to sow chaos.
As the previous debt limit fight back in 2011 showed, many lawmakers don't fear coming close to default. That year, the U.S. came within just a few days of a technical default with Standard & Poor's downgrading the country's credit rating in the aftermath of that fight. The bottom also fell out of the stock market that summer as lawmakers continued to spar over the issue.
Myers says brinkmanship could have even more dire consequences this time around, with possible credit downgrades for the U.S. and disruptions in Treasury Bonds and even in the U.S. Dollar.
While Biden tried to project optimism this week about the new dynamic, both Washington and Wall Street are bracing for new levels of political theater in 2023.
But as Drutman warns, “It's all brinkmanship until somebody miscalculates [but] every now and then somebody accidentally throws out the steering wheel and the thing crashes.”
Ben Werschkul is a Washington correspondent for Yahoo Finance.