Signs of progress over the last few weeks on budget negotiations in Washington have turned out to be a mirage. Negotiators appear no closer to a long-term budget agreement now than they were back in April when competing budget plans were presented by the House Budget Committee and the White House. New stop-gap plans are now being proposed in the Democratic-controlled Senate and the Republican-controlled House for passage this week. The chances of finding common ground look slim at this point. This budget drama may extend into mid-August, at which point the Treasury may be unable to meet all its payment obligations.
With the Treasury’s borrowing authority likely to be exhausted next Tuesday, 2 August, time is running out for an agreement that will prevent a possible default by the US Treasury on some of its outstanding obligations. More importantly for the long-run, the US government is also at risk of losing the triple-A credit rating bestowed on it by the three major rating agencies.
BACKGROUND REMINDER
The commonly accepted US government ten-year deficit projection is about USD9.0trn. A cumulative deficit that large will lead to an accelerating increase in the government’s debt to GDP ratio. To stabilize the debt-to-GDP ratio it would be necessary to reduce the projected ten-year deficit by USD4.0trn. This is the main reason why Standard & Poor’s has laid down a USD4.0trn deficit reduction as a condition for the US government to retain its triple-A credit rating. Indeed, S&P has warned that it is likely to lower the government’s credit rating to double-A from triple-A sometime in the next 90 days if progress is not made on a credible USD4.0trn deficit reduction plan.
Last year’s Fiscal Commission proposed a collection of spending cuts and tax increases that would meet the USD4.0trn target. The House Budget Committee plan presented earlier this year aimed at USD4.0bn in budget savings, as did the President’s counter proposal. The proposal cobbled together last week by the so-called Gang of Six in the Senate also tried to achieve a USD4.0trn ten-year deficit reduction. Clearly, the parties concerned know exactly how much they have to accomplish in terms of deficit reduction for economic and financial market stability. Unfortunately it looks like they will fail to reach that goal in the current round of budget negotiations.
Over the course of last week, Democratic and Republican negotiators appeared to be moving closer to a “grand bargain” that would result in a budget deal close to USD4.0trn. However, as of the end of the week, the negotiations broke down, and the chances of a USD4.0trn deal appear to have faded away completely. Instead, smaller deals are now being contemplated.
DUELING DEFICIT REDUCTION PLANS
As of this writing, the Senate Majority Leader (Democrat Harry Reid) is preparing a USD2.7 trillion ten-year deficit reduction plan combined with an increase in the debt ceiling of USD2.7trn. That is enough to give the Treasury enough borrowing authority to get through 2012. This is important since the Democrats want to avoid further debt limit deadlines dominating the legislative agenda in early 2012.
The House Speaker (Republican John Boehner) has put forward a two-stage plan aimed at USD3.0trn in deficit reduction. The House and Senate plans are moving along different tracks and do not necessarily overlap. This means it is unclear how a single piece of deficit reduction legislation can be voted out of both the House and Senate before the Treasury exhausts its borrowing authority on 2 August.
The Democrats’ Senate plan is being touted as meeting two essential Republican demands. First, it contains no revenue increases. Second, the proposed increase in the debt ceiling is matched by the projected reduction in the deficit. Since both of these conditions are met, the Democrats are inviting the Republicans to accept their proposal. However, the spending cuts proposed by the Democrats may not match those demanded by the Republicans. In particular, the Democrats want to count as spending cuts the likely reduction in military expenditures in Iraq and Afghanistan that will take place in coming years as these wars are wound down. Such “cuts” are not cuts in government programs, and do not restrain the growth of entitlement programs where most of the government’s future spending increases are located.
In contrast, the Republican plan in the House presented today by Speaker Boehner would involve, as a first step, a roughly USD1.0trn increase in the debt ceiling linked to USD1.2trn in discretionary spending cuts over ten years. The second step would involve the formation of a joint 12-member bipartisan House-Senate committee that would be required to come up with plans for another USD1.8trn in deficit savings. The committee would have to present its proposals before the end of this year and the proposals would be “fasted-tracked” through the legislative process with limited debate. The proposals could include revenue increases as well as spending cuts. Once the plans for USD1.8trn deficit reduction were approved, the debt ceiling could be raised another USD1.5trn.
The Administration and the Democrats in both the House and Senate are opposed to a short-term increase in the debt ceiling since it would raise the specter of debt default again in about six months. They do not want to go through another showdown over this issue with the Republican-controlled House still in charge of budget legislation. The Republicans may want to keep the deficit debate alive in 2012 in order to tie down the President during an election year and force him to continue to negotiate spending cuts in programs he is trying to protect.
COMPLEXITY AND CONFUSION STILL REIGN
At this point, it is not clear what will happen in the coming week. It appears that the Senate will move forward with Reid’s plan. But it requires 60 votes in the Senate to limit debate and it is not certain that 60 votes are available since the Democrats (and two Independents) have a majority of only 53 votes. Still some Republican Senators may vote for the plan just to move things forward. If the House passes Boehner’s new plan, it may die in the Senate since a majority of Democrats are opposed. The House, in turn, may not take up the Senate’s plan. This would bring us into next week with no resolution of the problem as the Treasury runs up against the limit of its borrowing authority on 2 August.
Though the Treasury will probably exhaust its borrowing authority on 2 August that date may not be the one on which the Treasury will be unable to meet all its payment obligations. The Treasury does carry a cash balance and it could probably pay its bills for a few days as it squeezes that balance down to the bare minimum. The Treasury might also be able to sell some assets such as MBS that it acquired during the financial crisis of 2008/2009. The actual day the Treasury will run out of cash may be closer to 15 August.
A few days leeway might allow a bit more time for a resolution of the debate surrounding the debt limit and the path forward for deficit reduction. Still, the threat of a rating downgrade is mounting. S&P has warned that it may lower the US government’s credit rating if the Treasury starts to forego scheduled payments, even if it is meeting all interest and principal payments on its outstanding debt.
More importantly, the latest deficit reduction plans put forward in the Senate and the House fall short of the estimated USD4.0trn necessary to stabilize the longer-term debt-to-GDP ratio for the US government. It is still possible that a “grand bargain” of some sort could emerge in the coming week or ten days that would meet that requirement, but as of today, it appears that the budget negotiators in Washington are giving up on the USD4.0trn deficit reduction target for the time being. If that is the case they may also be giving up the government’s triple-A rating.
HSBC Global Research