Debt Outlook Stark

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Posted: Jul 13, 2011 12:01 AM

Congress and the President are down to the wire on cutting a debt limit deal. The President's goal haqs been to sound fiscally conservative, make clear the August 2 deadline, point to the need for a combination of spending cuts and tax increases, and encourage more discussions.  
 
  • It's still possible that the two parties will agree to a scaled-down deal based mostly on spending cuts.  However, the Biden $2 trillion package probably can't get the required 50% of the House.  It includes tax increases not offset by tax rate cuts, leaves spending growing fast from the current high level, relies on "interest not paid on debt not incurred" for part of its savings, and hurts seniors and other taxpayers by changing indexing formulas from CPI-W to the less-inflationary chain-weighted CPI (that's the normal headline reading announced monthly.)  The CPI change hits seniors by reducing their cost-of-living increase a bit (due for a bump in December after two 0% COLAs in 2009 and 2010.)  The CPI change also hits income taxpayers by holding down the inflation-adjustment in the tax bracket thresholds causing more bracket creep.
 
  • Because the Biden package is probably a non-starter, there's a fall-back under discussion -- a mini-deal for only a TARP-sized $800 billion or so debt limit increase.  There would be $1.5 trillion-$1.8 trillion  of reductions in spending growth (over 10 or 12 years), minimal tax increases, and a nod toward considering a balanced budget amendment (this gives members cover to vote for more debt.)  This smaller debt limit increase would last through about December, the time of year Congress will be most able to cut another deal in order to kick the can past the 2012 election and get home for Christmas (like the 2010 deal to extend all the tax cuts and loopholes and keep 99-week unemployment benefits for another year.)  
 
If they don't reach an agreement, we think Treasury will be able to make the August 2 deadline stick, meaning construct the legal justification for non-payment of obligations.  (We don't think there is any consideration in Treasury of trying to apply the 14th amendment in order to issue more debt.) 
 
To meet the August 2 deadline for enacting the actual law increasing the debt limit, the Administration has said it needs an agreement to be reached by Friday July 22.  Early the following week, we think Treasury may warn that it is preparing to send out letters warning of payment cutbacks.  This would allow news-intensive weekdays on July 26-28 for full communication of the damage before sending out the letters.  Some possible communications:
 
  • Letters that student loans for the soon-to-start academic year might not be disbursed.
  • Letters to seniors warning that automatic deposits for social security cannot be assured starting August 3.
  • Letters to doctors and hospitals that processing may stop on Medicare-related health care payments. (This would give doctors another reason to stop seeing Medicare patients.)
  • If still nothing happens by August 2, it is unclear whether Treasury will also delay interest payments on bonds.  Our view is that it won't delay those payments.  It was done in April-May of 1979, but we think markets are so much more dependent contractually on timely interest payments that Treasury will take all available methods to avoid this step.
 
Fiscal impactWe expect Washington to continue its super-loose fiscal and monetary policy, sustaining the weak dollar trend and the heavy outflow of U.S. capital to Asiaand elsewhere.  Under current U.S. policies -- weak dollar, expanding government control, and the near-zero Fed funds rate that forces credit rationing -- we expect spending and debt to continue growing at or above the rapid rate projected in CBO's alternative scenario (where marketable debt rises to 85% of GDP in 2016 and 100% of GDP in 2021.)  In calculating this scenario, CBO assumes strong growth, no recessions and relatively low interest rates, meaning the fiscal deterioration would go faster than that unless the economy takes off.
 
Market impact: We've argued that bond and currency vigilantes will push other heavily indebted countries (like Greece and maybe Italy) to tipping points before pushing the U.S.which could continue declining for several more years as wealth, capital and jobs dissipate gradually. 
 
  • We think Treasury bond yields will stay very low as this drama over the August 2 deadline unfolds.  Bonds and gold are a form of insurance against deflation and inflation (the barbell trade we described in 2010) on the view that mistakes happen and something might go dreadfully wrong in the game of chicken.  We expect bond yields to rise once the debt limit is increased, even if it's only an $800 billion TARP-sized increase.  Equities have a thick skin, so will probably focus more on Italy, earnings and growth unless August 2 is actually reached without a deal.
 
Political impactWe think the "mini-deal" described above is the best outcome now available for fiscal conservatives. As we've written since January, we think the debt limit increase could have been used to force Washington into more restrained spending procedures but wasn’t. Republicans have gotten boxed into a no-win situation by negotiating privately with VP Biden, letting the President off the hook on identifying spending cuts, and allowing a time deadline where the Administration can control communications as it shuts down popular payments (the Mack truck in the game of chicken).  
 
  • Our view: The current debt limit is harmful because it doesn't help control spending and leaves fiscal conservatives with the bad choice of voting for an increase, risking default or letting the president withhold popular payments.  It should be replaced with a new ceiling providing sticks and carrots that force Washington to control spending -- but with no threat of defaulting on debt.  The most likely outcome of the current process is an increase in the current statutory ceiling, a minor reduction in spending growth, no default, and a focus on the 2012 election. 


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