As we get closer and closer to deadlines on a debt ceiling limit it’s time to look into what’s really going on and how it will affect the markets. In case you haven’t been paying close attention, (and I don’t blame you if you haven’t, this stuff will make you dumber for having watched it play out) Congress and the President are in the midst of protracted negotiations on a budget deal. This is something that is quite common, especially during times of split party rule between the White House and the House of Representatives.
What’s different this time is the party in power in the House, the Republicans, have decided to use what has historically been a uneventful procedural vote over the Debt Ceiling as a negotiating tool. The Debt Ceiling vote is a curious remnant from earlier times, usually divorced from the actual budget negotiations. From Wikipedia:
Article I Section 8 of the United States Constitution gives the Congress the sole power to borrow money on the credit of the United States. From the founding of the United States through 1917 Congress authorized each individual debt issuance separately. In order to provide more flexibility to finance the United States’ involvement in World War I, Congress modified the method by which it authorizes debt in the Second Liberty Bond Act of 1917, Under this act Congress established an aggregate limit, or “ceiling”, on the total amount of bonds that could be issued.
The modern debt limit, in which an aggregate limit was applied to nearly all federal debt, was established in 1939. The Treasury has been authorized by Congress to issue such debt as was needed to fund government operations as long as the total debt (excepting some small special classes) does not exceed a stated ceiling.
As of July 2011, the United States is effectively at the limit of Congressionally authorized debt. Congress is now considering whether and by how much to extend the debt ceiling.[dated info] An issue of note is that failure to extend the limit may leave the federal government unable to pay all its obligations, including paying interest on existing debt, a default that could have serious repercussions.
In the current negotiations, the battle lines are fairly clear. From the NYT:
Now consider the positions of the respective parties to the negotiation. One framework that President Obama has offered, which would reduce the debt by a reported $2 trillion, contains a mix of about 17 percent tax increases to 83 percent spending cuts. Another framework, which would aim for twice the debt reduction, has been variously reported as offering a 20-to-80 or 25-to-75 mix…
…However, all but 7 Republicans in the House of Representatives, or 97 percent of them, have signed the pledge of Grover Norquist’s Americans for Tax Reform stating that any net tax increases are unacceptable. One might have believed this to be simply a negotiating position. But the proposal that Senate Republican leader Mitch McConnell floated yesterday, which would give up on striking a deal and instead rely on some procedural gymnastics to burden Mr. Obama with having to raise the debt ceiling, suggests otherwise. Republicans in the House really may be of the view that a deal with a 3:1 or 4:1 or 5:1 ratio of spending cuts to tax increases is worse than none at all.
What is a little unclear is exactly how this will end. The markets are indicating very little probability that a deal will not be reached. But you never know. I think a deal will eventually be reached. The problem is it may take a little fear of a default from the markets in order for that to happen. The ratings agencies, worried about this insanity actually playing out, are trying to get ahead of it by stating exactly what the ramifications would be:
At least 7,000 top-rated municipal credits would have their ratings cut if the U.S. government loses its Aaa grade, Moody’s Investors Service said.
An “automatic” downgrade affecting $130 billion in municipal debt directly linked to the U.S. would occur if the federal level is reduced, Moody’s said yesterday in a report. Additionally, top-rated securities with no direct links to the national government will be reviewed for similar action.
Not pretty. The Doomsday Scenario in my opinion would be something similar to what we saw with the first TARP vote in 2008. Where the initial proposal from Treasury was voted down by House Republicans, sending the Dow down more than 700 points intraday:
Following the House vote, the Dow Jones Industrial Average dropped over 777 points in a single day, its largest single-day point drop ever. The $1.2 trillion loss in market value received much media attention, although it still does not rank among the index’s ten largest drops in percentage terms. The S & P lost 8.8%, its seventh worst day in percentage terms and its worst day since Black Monday in 1987. The NASDAQ composite also had its worst day since Black Monday, losing 9.1% in its third worst day ever. The TED spread, the difference between what banks charge each other for a three-month loan and what the Treasury charges, hit a 26-year high of 3.58%; a higher rate for inter bank loans than Treasury loans is a sign that banks fear that their fellow banks won’t be able to pay off their debts.
This failed first vote was reportedly in part because Nancy Pelosi hurt some Republican House Members’ feelings in a pre-vote speech on the floor. I bring this last point up to emphasize just how childish the House can be on matters of importance.
So what might happen with the Debt Ceiling votes? My assumption, and also the assumption of alot of market participants, is that a deal will get done. But you can’t assume there won’t be some market moving shenanigans along the way. If anything, the House Republican caucus has become more ideologically rigid following the 2010 elections. Alot of their members are serious about this stuff, and some indications are that Republican leadership has lost control of its caucus.
“Where’s your paper?” [Cantor] asked angrily.
Obama snapped back: “Frankly, your speaker has it. Am I dealing with him, or am I dealing with you?”
Despite these factors, I still think a deal will ultimately get done. But let’s look at what that deal could look like.
Reducing government spending and raising taxes during a high unemployment, low demand weak recovery is anti-stimulative. Full stop. When a deal is ultimately done, that mix of spending cuts and higher taxes will be an additional drag on the economy. Recent reports are indicating that the tax portion of the deal could be particularly bad for stocks:
Let me explain this one to laypeople. Obama’s deal on taxes was that he proposed to start with the revenue levels we’d have if the Bush tax cuts only on income over $250,000 phased out. But, to assuage Republican concerns about higher tax rates, he agreed to tax reform that would drop the rates back down to Bush-era levels, and make up the lost revenue by closing tax preferences.
Now, here is where things broke down. To do that in a way that means the progressivity of the tax code, you’d almost be required to reduce or eliminate the tax preference for capital gains. That’s how the Reagan administration and Democrats did it when they reformed taxes in 1986 — they dropped the top tax rate from 50% to 28%, but the rich wound up paying more because they ended the preference for capital gains.
I think a final deal will look something close to this. Politicians hate to raise income taxes. It makes for bad headlines. But ‘closing tax loopholes’ polls a lot better.
I imagine the announcement of a deal, which could come at any moment, in the next few days or weeks, would cause a sharp relief rally. I would be skeptical of this rally. These negotiations have been a sideshow. The market hasn’t been factoring in much of a chance of default, and an announcement of a deal that does avoid default would be creating value out of thin air. What the market would then have to look at is the continuing slow pace of the recovery and what a budget deal that cuts government spending and raises taxes does to that slow recovery.