Presenting The Capeless Crusader: The Deficit (Non) Super Committee

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While the soap opera in Europe lurches from one extreme to another, in the process creating substantial market knee jerk reactions, even though the final outcome is quite clear to most with cognitive bias blinders, the next major catalyst in the macro spectacle will come not from across the Atlantic, but from these here United States, in the form of the Super Duper Committee tasked with finding the $1.2 trillion in deficit cuts needed in order to make the August debt ceiling hike legitimate. As a reminder the debt back then was $14.4 trillion - tomorrow it will officially surpass $15 trillion for the first time ever, meaning that even as the Super Committee squabbles, half the benefit from its "successful" conclusion has already been implemented. And here is where Morgan Stanley's David Greenlaw comes in with a piece in which he makes it all too clear that the Super Committee may be Clark Kent, but it sure is no Superman. "Press reports continue to suggest that the so-called Super Committee, established as part of the compromise agreement to hike the debt ceiling, is foundering. In recent days, Democrats and Republicans have offered competing plans that have little common ground. Republican members appear to remain committed to a no new taxes pledge, which will make it very difficult for the Committee to come anywhere close to its $1.2 trillion target." In other words, just as nothing material or actionable (suffice for some grandiose delusions) came out of Europe, precisely the same will happen in the US, after our own dire fiscal situation is exposed for the naked emperor it is.

From the very same Morgan Stanley: "There is still a very wide range of possible outcomes, but our baseline expectation at this point is that the Super Committee will agree to $500 billion or so of deficit reduction (a significant portion of which may wind up being budgetary gimmickry that will not lead to any real deficit reduction). This means that $700 billion or so ($1.2 minus $0.5) of automatic deficit reduction would be slated to trigger in 2013. Of course, Congress and the Administration (either current or incoming) would still have an opportunity to override the automatic cuts at some later date." It's good that a major bank acknowledges that we have "budgetary gimmickry that will not lead to any real deficit reduction" to look forward to. In other words: expect the market to do what it does best: surge and/or levitate on no real news to sell off to, while at the same time nobody even pretends any more to have a remotely actionable resolution to anything.

From Morgan Stanley's David Greenlaw

The Super Committee Doesn’t Have a Cape

Press reports continue to suggest that the so-called Super Committee, established as part of the compromise agreement to hike the debt ceiling, is  foundering. In recent days, Democrats and Republicans have offered competing plans that have little common ground. Republican members appear to remain committed to a no new taxes pledge, which will make it very difficult for the Committee to come anywhere close to its $1.2 trillion target.

The smartest thing that the Committee members have done to this point is to hold most of the meetings behind closed doors and avoid leaks to the media. This has helped to prevent a situation similar to the one which played out over the summer, when a constant drumbeat of political bickering seemed to negatively impact investor sentiment. Also, in hindsight, the debt ceiling stalemate appears to have had a powerful negative effect on sentiment along Main Street. For example, the chart below shows the results of a simple question related to perception of the government’s economic policies that is asked every month as part of the University of Michigan’s consumer confidence survey. The results show that negative sentiment reached an all-time low in August (using data back to the inception of the survey question in 1978) and remained quite depressed into September and October.

As the Super Committee heads toward the November 23 deadline, they will be forced to emerge from the darkness. Indeed, given that CBO will need at least a week or so to score whatever proposal emerges, the real deadline for an agreement is even sooner. Moreover, the threat of another government shutdown looms as a separate issue. The Federal government is currently operating under a continuing budget resolution that expires on November 18, and some  Washington watchers are anticipating another contentious battle. Indeed, nearly one full month into the new fiscal year, none of the 12 budget appropriations bills has been enacted. So, beginning soon, we expect more press coverage and a greater public awareness of the degree of political gridlock. This may pose some economic risk because the Super Committee’s deadline is the day before Thanksgiving – right in front of the biggest holiday shopping period of the year!

There is still a very wide range of possible outcomes, but our baseline expectation at this point is that the Super Committee will agree to $500 billion or so of deficit reduction (a significant portion of which may wind up being budgetary gimmickry that will not lead to any real deficit reduction). This means that $700 billion or so ($1.2 minus $0.5) of automatic deficit reduction would be slated to trigger in 2013. Of course, Congress and the Administration (either current or incoming) would still have an opportunity to override the automatic cuts at some later date.

From our perspective, it’s unclear whether Super Committee gridlock would prompt a credit downgrade, given the automatic spending cuts that serve as a backstop. But, as we learned in the initial episode with S&P back in the summer, the ratings agencies can make up their own rules as they go along. The somewhat arbitrary nature of a rating decision makes it very difficult to handicap. Similarly, it’s hard to understand why the financial markets would care if Moody's and/or Fitch joined S&P in downgrading the US, but I suppose you could get another risk-off trade leading to a rally Treasuries. However, it seems likely that the impact would be far more muted today than what occurred after the S&P announcement. Markets should now realize that a credit rating for a  sovereign such as the US – which has the power to tax, borrow or print money – is essentially meaningless. As our sovereign credit strategist Arnaud Marès has explained, a credit rating for a developed economy with its own currency basically represents an evaluation of long-run inflation risk – making it even more puzzling why inflation expectations collapsed after the initial S&P downgrade.

We continue to encounter a great deal of concern regarding near-term fiscal tightening in the US. However, we believe that this reflects some confusion regarding the timing of the actions related to the Super Committee and other factors. It’s important to recognize that just about all of the deficit reduction tied to the Super Committee (or the substitute automatic spending cuts) will not kick in until 2013. The major near-term uncertainty on the fiscal policy front involves the payroll tax cut, investment tax incentives, and unemployment benefit provisions that are scheduled to expire at the end of 2011. Together these programs are worth about $175 billion – or a little more than 1% of GDP. Most Washington experts believe that these measures will be extended, but there is  no obvious vehicle to getting this done and it is far from a sure thing. So, there is valid concern about meaningful fiscal tightening in 2012 – but only if the expiring provisions are not extended.

Looking further ahead, there could be a very sizable tightening of fiscal policy in 2013 depending on the outcome of the Super Committee deliberations and the fate of the Bush era tax cuts (which are slated to expire at the end of 2012). Obviously, the election outcome will be an important determining factor, but this means that business and consumer caution tied to policy uncertainty could continue to plague the US economy for quite some time.