Perspectives On The Debt Ceiling Debate

By Charles Webb

"For those who say further responsible spending reductions are not possible, they are wrong. . . For those who say more taxes will solve our deficit problem, they are wrong. Every time Congress increases taxes, the deficit does not decrease, spending increases." – Ronald Regan

The debate over the U.S. statutory debt limit has come down to the wire. The U.S. Treasury has stated that if an increase in the debt ceiling is not in place by August 2nd, they will run out of funds to pay all of their bills. Yet with just days left before the deadline, political brinkmanship in Washington shows no sign of letting up.

There are so many ways in which this political crisis can play out. Each one is further complicated by the fact that there is no way of knowing precisely how financial markets will react if this deadline is breached. For decades, U.S. Treasuries have served the global financial markets as an unquestioned source of liquidity. When this conventional wisdom is thrown out the window, the world looks like an unpredictable place and financial markets hate unpredictability.

As we see it, there are four possible outcomes. The first and most desirable outcome is that a consensus is formed around a spending plan that puts this country on a sustainable fiscal path. By contrast, the current path is quickly running out. The can has been kicked down the road so many times that the road has simply run out. Even the Congressional Budget Office acknowledges that our current situation is unsustainable.

Scenario 1

This best case scenario would immediately raise the debt ceiling, putting any short-term uncertainty to rest, and institute a fiscal austerity plan in place that would bring the country’s outstanding debt to within a reasonable percent of GDP. In the short-term, stocks would rally, Treasury spreads would narrow and the dollar would strengthen. Medium-term, this would put downward pressure on economic growth and slow the recovery. Four trillion dollars in cuts over ten years, it is estimated, would reduce GDP by about 0.5% per year for the next five years. This deleveraging cycle would be very similar to what we’ve seen in the private sector over the last three years; a sharp impact short-term but lasting benefits long-term. It would be the take your medicine now approach.

Scenario 2

Similar to the first, scenario two would have a last minute deal struck by Congress and government operations would not be interrupted. However, this deal involves only an incremental increase in the debt ceiling in exchange for ongoing discussions on a larger fiscal agreement. Standard & Poor’s has repeatedly stated that they would still consider downgrading the status of U.S. debt if they believe a credible long-term solution to the rising debt burden has not been found. However, even if this were to occur, it would likely have a relatively minor impact on the U.S. economy as other ratings agencies do not appear inclined to follow.

With the risk of a shut down in government operations and a debt default having been averted, we suspect markets would take a downgrade by a single agency in stride. Nonetheless, worries about the long-term prospects to deal with the fiscal imbalances would persist. This scenario would bode for continued weakness in the U.S. dollar, but not a sharp decline from current levels. Bond yields would be largely unaffected, as markets would go back to fretting about the sub-par pace of economic growth.

Scenario 3

The third scenario arises if the political impasse takes us past the August 2nd deadline. In all probability, this would eventually be followed by a ratings downgrade by Standard & Poor’s, and there would certainly be heightened risk of action by other rating agencies.

In this scenario, we end up with a double hit on the economy. The first hit comes from the direct impact of withdrawing government funds from the economy equal to their financing shortfall - estimated to be $135 billion for the month of August. The second hit comes from the indirect impact of a potential rise in Treasury yields and flight out of equities due to deteriorating market sentiment.

There is no way in knowing how long the political impasse would last if it were to occur. If we assume a political resolution is not found for the entire month of August, a reduction of $135 billion from the economy would equate to an annualized 1.5 to 2 percentage point drag on GDP growth in the third quarter. The market reaction would be serious. At the very least you would see a flight out of risky assets, like equities. Similarly when Congress initially failed to pass the TARP legislation in late 2008, the S&P 500 suffered one of its largest single day drops on record (-9%).

The likely public reaction would certainly lead to a quick compromise in Washington and much of the market reaction would reverse itself. However, the lost GDP would leave the economy in much worse shape than it is today. Overall, the impact would be directly related to the length of time past the August 2nd deadline it took to reach an agreement.

Scenario 4

In this scenario the U.S. government actually defaults by not making or is late in making its interest payments. This would be totally unimaginable and we don’t think there is a remote chance of this happening. This event would take us into uncharted waters in modern finance.

Financial markets would simply freeze. Every asset class would drop in value. Stocks, bonds and even money markets would take severe hits. It’s even uncertain what commodities like gold would do. An economic recession/depression would surely follow from the total freeze in U.S. credit markets.

A Little of Our Opinion

Depending on how long it takes Congress and the President to reach an agreement, the impact could range from a short-term negative to disastrous. The financial market’s impact will depend on how long this impasse takes to get resolved.

It must be recognized that federal spending must be sharply reduced to stabilize the debt to GDP ratio. As we’ve stated before, this is a spending problem and not a revenue problem. As such, this situation must be confronted from that perspective and there will be some negative economic effect from this deleveraging.

To try and address this issue by raising taxes is counterproductive in our opinion. It’s important to understand that there are three basic inputs to production (GDP): materials, labor and capital. These are not substitutes for one another but instead must be used together. When the government collects taxes or runs up debt, it is consuming capital that would otherwise be available to the private sector and thus retards economic growth.

In the current debate we’ve heard a lot about taking a balanced approach to fixing this crisis. This of course means raising taxes as well as cutting spending. Our objection to this is that taxes are already going up almost a trillion dollars beginning in 2013 due to the healthcare legislation passed last year. We don’t think that adding more taxes in this economic environment is a good idea nor do we think it would help long-term. Clearly government is necessary and must be funded, but to what extent? I’m reminded of the saying that traffic will always fill the roads, meaning that no matter how many times you expand the freeways, traffic will always increase to the road’s capacity. Government spending is much the same way. No matter how much is collected in taxes, politicians will always find a way to spend it – and then some. This is how votes are bought and constituents pleased.

The Bottom Line

We think that scenario 2 is the most likely outcome. We also think that the debt ceiling increase will get finalized at the last minute and maybe even a day or two after August 2nd. Expect the markets to be volatile over that time and the news to be disheartening. We strongly believe it would be a mistake to change or make any investment decisions based on this news. Whatever hedges that could be put in place would be destroyed once a compromise was reached.

You’ll hear a lot of news about our AAA credit rating. While this shouldn’t be taken for granted, the reality is that there is enough demand in the treasury market that it will look through what is clearly a political event and not a true default.

In the end, the markets will trade on the fundamentals of the economy and not the headlines. That’s what we’re focused on when it comes to our clients’ portfolios. We still feel pretty good about the fundamentals.