Goldman On The Debt Ceiling Increase : "How, What, And So What?"

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Whereas two days we presented what the Treasury's options are to extend the inevitable moment before the debt ceiling is hit (which , today Goldman's Alec Phillips analyzes another angle of the ceiling hike: what the congressional debate on the debt ceiling rise may look like. While everyone is certain that the ultimate fate of the debt target, pardon, ceiling issue is a given, and that the UST will end up hiking it by another $1.5 trillion, little has been said about just how we get there. From Goldman: "Split control of Congress is apt to lead to a longer-than-usual debate over increasing the statutory debt limit, and could result in at least one failed attempt at an increase before the limit is raised. It also looks possible if not likely that Congress could approve at least one short-term increase in the limit as the debate unfolds, the first such stopgap since 1996." Yet no matter what how heated any debates, the final outcome is certain, and at least according to Goldman, should be priced in: "Although the debate over the debt limit is likely to capture the market’s attention from time to time, the overall effect of the debt limit debate is apt to be modest. Looking back to the 1995-1996 episode, there is little evidence that the most important legislative developments in that period had an effect on Treasury yields." In other words, the US will continue issuing $125 billion in debt per month, while US GDP grows at one sixth this rate, confirming that the hyperinflationary toxic loop of failed monetary policy is beyond repair. That said, we agree with Goldman - the debt ceiling will be raised as the alternative will be another round of mutual assured destruction from everyone. The same thing is true for 2012, when the next debt ceiling hike will need to take place. Then in 2013, then in 2014, and after that the debt ceiling will be raised on a daily basis.

Increasing the Federal Debt Limit: How, What, and So What?

From Alec Phillips of Goldman Sachs

Yesterday’s US Daily (Zero Hedge link) looked at the mechanisms the Treasury may use to buy time under the debt ceiling while Congress debates an increase (see “The Treasury’s Options as the Debt Ceiling Approaches,” US Daily, January 31, 2011).  Today’s comment looks at how that debate may unfold, what Congress may ultimately decide on the issue, and how the market has reacted to previous similar episodes. Congress faces two related but separate issues over the next few months: 
 
1. The continuing resolution (CR). The current stop-gap funding for certain government operations, known as a continuing resolution, expires March 4. If Congress fails to extend it or enact appropriations for the remainder of the fiscal year, “discretionary” programs would in most cases cease to operate (“essential” services, as defined by the president, would continue).  Such an event would make headlines but should have no effect on holders of Treasury securities, nor should it affect recipients of most federal benefit programs, as these are “mandatory” programs and unrelated to the congressional appropriations process.  The House looks likely to pass a spending bill for the remainder of the fiscal year the week of February 14—at a spending level around $100bn lower on an annualized basis than the current level. The Senate will probably move more slowly, and is likely to pass a bill much closer to the current level of discretionary spending. 
 
2. The debt limit
.  The statutory limit on the amount of outstanding federal debt is likely to be hit at some point around the middle of the second quarter and, as outlined in yesterday’s daily, the Treasury has options to buy additional time.   For the next few months this should have little effect at all apart from rearranging some internal and external liabilities.   However, if the Treasury exhausts other options on its balance sheet, continued failure to increase the limit would force the administration to choose between paying creditors and interrupting government services. If forced to choose, we assume an interruption of government services would come first. This is a very unlikely scenario, but it is the risk that could increasingly worry market participants.
 
What the debate may look like:
Although the Treasury has formally requested that Congress increase the debt limit, there has been little congressional debate thus far. A few general observations on how the debate might play out:
 
1. Split control of government—and particularly split control of Congress—will slow passage... Since 1940, Congress has increased the debt ceiling 100 times.   Most of these have been fairly routine, particularly when Congress is controlled by one party and especially when the president is also a member of that party.  Others were tacked onto major pieces of legislation, like the Balanced Budget Act of 1997.  This leaves relatively few recent episodes held under circumstances similar to today’s, namely 1995-1996, 2002, and 2007 along with a string of smaller increases in the 1980s. Some of those debates—particularly in 1995-1996—lasted for months and involved threats of default on Treasury debt from some members of Congress.
 
2. …And could make for some political turbulence.  This time around, members of Congress face a collective responsibility problem; many Republicans view this as the administration’s problem rather than their own, while Democrats in the House are now in the minority and believe it is the majority party’s responsibility to vote for the increase. This is somewhat reminiscent of the debate over the Emergency Economic Stabilization Act (EESA) which authorized the TARP program in 2008. Neither party viewed passage to be its sole responsibility, and the bill failed to pass on the first attempt. The result this year seems likely to be passage in the Senate with Democratic votes, and passage in the House with a mix of Republican and Democratic votes, but a failed first attempt can’t be ruled out.
 
3. Small and/or temporary increases could precede a large permanent increase.   From 1954 to 1983, Congress periodically enacted temporary increases in the debt limit, set to expire on a certain date.   Permanent increases have since become the norm, with temporary increases enacted during those debates only as short-term stop-gap measures.  If the debt limit bogs down in Congress, it is very possible that a short-term extension will be approved instead. For instance, in 1996, Congress passed short term extensions to allow the Treasury to issue Social Security checks; after months of debate, a permanent increase was approved one day before that extension was due to expire. 
 
4. The ceiling probably won’t be raised until the last moment.   Virtually every large increase in the debt ceiling since the early 1980s has been preceded by the Treasury’s exhausting its capacity under the limit and taking actions to avoid breaching it, such as rearrangement of internal trust fund liabilities.  The final agreement is usually brought about by an upcoming congressional recess, a debt-limit related deadline like those noted above, or both. 
 
What Congress may ultimately decide:  Ultimately this boils down to two questions: how much will the limit be increased (or for how long), and with what in return?   The two questions are related; some House Republicans, for instance, have implied that a larger increase is likely to receive their support only if it is coupled with substantial reforms.
 
1. Modest spending cuts seem likely.   This is the most obvious area for agreement, since each party simply needs to pick a number that it believes is an appropriate level of spending and work their way to common ground.  House Republicans have proposed cutting non-defense discretionary spending for the second half of the current fiscal year by $100bn on an annualized basis. President Obama has proposed freezing that segment of the budget for five years starting next year.  This issue will be decided as part of the process of extending the continuing resolution, so it will color the debt limit debate but won’t be directly tied to it. 
 
2. Spending caps are possible.  Two proposals are on the table: the president’s fiscal commission’s recommendations, which would have capped discretionary spending for total savings over ten years of $1.7 trillion, or the more recent proposal from Senators McCaskill (D-MO), Corker (R-TN), and Isakson (R-GA) to apply gradually decreasing caps to overall spending as a share of GDP, reaching 20.6% by 2020.  Both of these would be a challenge, but the former appears more likely than the latter, given that even the sponsors of the 20.6% of GDP cap have indicated they will not make their support for a debt limit increase contingent on their proposal being included in the package.  One option that may allow for a compromise in this area is simply to reduce the number of years covered by the cap.
 
3. Long term entitlement reforms are unlikely to be addressed in this debate. Policymakers across the political spectrum agree that health spending is the most significant long-term fiscal challenge, but there appears to be little appetite to address it now, and in any case the issue is too complex to attach to a debt limit deal that is likely to be reached at the last minute.  The odds that Social Security reforms will be addressed in this debate are only slightly better; although some Republican members of Congress have indicated that they will demand changes to Social Security as a condition for their support of a debt limit increase, the debt limit increased is expected to pass the Senate with mainly Democratic support, and some Senate Democrats oppose the commission’s recommendations in this area, at least on a standalone basis.
 
4. Taxes probably won’t be part of the discussion.  With most major tax provisions set for another two years, and the tax reform discussion barely off the ground, tax issues seem unlikely to be addressed as part of a debt limit compromise, despite comments from some senators that they will push for tax reform during this process. House Republicans are very unlikely to vote for any tax increase as part of a debt limit compromise, but the absence of any revenue increases will make many Democrats less likely to support entitlement reforms.
 
5. A constitutional amendment is an interesting wildcard but faces too high a hurdle.  A number of Republicans have proposed a constitutional amendment requiring a balanced budget, which yesterday attracted its first Democratic support in the Senate (Sen. Mark Udall, D-CO) and seems to be gathering some momentum. While a constitutional amendment, with carefully crafted allowances for countercyclical policies and emergencies, could improve the current budget process by imposing a binding restriction on Congress that other fiscal rules cannot, it is also the most difficult to enact; a two-thirds majority vote in both chambers of Congress is required, along with ratification by three-quarters of state legislatures. In modern times, amendments have taken years to work through the state ratification process, with the exception of repeal of prohibition.  (For more on fiscal rules, see “Squaring the Fiscal Circle: Could a Fiscal Rule Help? US Economics Analyst 10/29, July 23, 2010).
 
The potential market effect of a debt limit debate (or CR-induced government shutdown) is hard to predict, but even if rhetoric intensifies substantially, the overall impact should be limited. Looking back to the 1995-1996 period, there appears to have been a brief rise in the yield on the 10-year note when the three-week government shutdown began on December 16, 1995, but it returned to pre-shutdown levels within three days. The first shutdown, which lasted two days in November 1995, had no apparent effect.  The various moves that the Treasury took to create headroom under the limit also do not appear to have had a noticeable effect on yields. Moreover, as the debt ceiling neared resolution March, Treasuries were selling off. Looking back at news coverage and our own research at the time, the move was due to more optimistic growth expectations than the debt limit showdown or the failure to enact pending balanced budget legislation (it eventually passed in scaled down form in 1997). 
 
In summary, although some members of Congress have the incentive to threaten to hold up a debt limit increase to increase their political leverage and win fiscal concessions, we have no doubt that the limit will ultimately be increased, so any disruptions should be temporary.