Having passed the 'easy-do-nothing' bill that created a 5% uplift in US equities, D.C. have left the most difficult set of issues for last: entitlement reform, which Republicans have said they will insist upon in return for raising the debt limit, and tax reform, which the President has said he will insist on in return for entitlement reform. The upshot is that reaching an agreement on the next debt limit increase could be at least as difficult as the last increase in August 2011. As Goldman notes, over the next two months, policymakers will have to focus on three issues: (1) how to raise the debt limit, which will begin to constrain Treasury borrowing by early March; (2) whether to reform entitlement programs and/or the tax code to reduce spending or increase revenues by a similar amount as the increase in the debt limit; and (3) how to address the spending cuts scheduled to take effect under the "sequester," which was delayed to March 1. The next debate on the debt limit will be the fifth "showdown" on fiscal policy in the last two years. However, one new twist to this now familiar routine may come from the rating agencies, which look likely to be more active in 2013 than they have been since 2011.
Via Goldman Sachs,
We had previously estimated that fiscal policy at the federal, state, and local level would weigh on growth by 1.6pp on a Q4/Q4 basis in 2013; we believe the final package will be similar at around 1.5pp drag on growth. As before, we expect the effects to be weighted toward first half of the year, as shown in Exhibit 1.
One aspect of the fiscal cliff remains somewhat uncertain. The spending cuts under "sequestration" that were slated to begin January 1 2013 have been delayed until March 1 as part of the compromise just passed. Lawmakers are apt to attempt to delay sequester implementation further, probably once again taking a piecemeal approach and enacting a temporary delay of a few quarters or a year.
Although we continue to think Congress will delay the sequester at least once more, it does seem likely that it will eventually take effect, or at least that policies targeting some of the same areas of the budget (i.e., defense and domestic appropriations) will be implemented instead.
Raising the debt limit will be the more significant policy challenge over the next couple of months. Congress last raised the debt limit in August 2011. The Treasury formally reached the debt limit of $16.394 trillion on December 31, 2012 and is now operating under "extraordinary measures" (accounting strategies used to minimize Treasury securities held in government accounts). While the timing is always hard to predict, at this point it appears that the Treasury will exhaust its financing capacity by March 1, when it must make a number of large monthly payments, particularly related to Social Security and Medicare. Congress will need to raise the debt limit by that point if it has not already. While a failure to raise the debt limit should not have implications for the Treasury's ability to make interest payments or to redeem existing securities, it could lead to a sharp reduction in spending, including fiscal transfers to individuals, payments to contractors, and payment of tax refunds which tend to be fairly heavy during this period.
Unfortunately, the upcoming increase may be more difficult to enact than the increase in 2011. Few spending cuts had been enacted before the previous increase, which left lawmakers with several areas of the budget from which to pull potential savings. Congress eventually settled on $2.1 trillion in spending cuts, essentially all coming from a reduction in spending appropriated by Congress (about $900bn from caps on "discretionary" spending, and $1.2 trillion from "sequestration"). While hardly non-controversial, these cuts did not affect specific programs but instead capped overall spending, thus reducing political opposition. The fiscal agreement Congress just passed increases revenues by about $600bn over 10 years (compared with a full extension of expiring income tax cuts), and while this second round of savings was much more controversial than the first, a majority of the public supported the tax increase, which was targeted on high incomes.
If lawmakers continue to target a stabilization of the debt to GDP ratio over the next several years, they would need to go further than the two packages enacted since 2011. Most of the high-profile fiscal reform proposals offered over the last couple of years target around $4 trillion in savings over 10 years, or a bit more than $1 trillion beyond what has been agreed to already. A one-year extension of the debt limit would also require an increase of around $1 trillion, making this an obvious target for the next round of deficit reduction talks. However, this would be a difficult goal to reach, for several reasons:
- Both parties have proposed some additional spending cuts, but neither has specified this magnitude of cuts: Republican leaders have said they want structural entitlement reforms as part of a deficit reduction package, but have not been very specific in their proposals. The President has been more specific in his budget, but proposes a smaller amount of entitlement-related cuts, and most of them relate more to payment rates for health services and products rather than changes to benefits or eligibility. It is simply politically more difficult for either party to propose, let alone agree on, significant cuts to entitlement programs than it is to make just about any other change to fiscal policy. However, this is the only major area of the budget that hasn’t been addressed in the fiscal reforms to date.
- The President says he will not negotiate on spending cuts as part of a debt limit increase. President Obama has indicated he will not negotiate with Republicans on spending cuts for the next debt limit increase. Since a prolonged failure to raise the debt limit is politically unsustainable, the White House may simply decide congressional Republicans will eventually vote to raise it.
- Tax increases would become part of the debate if entitlement reforms are considered. Although the President has indicated he will not negotiate on the debt limit, he has also indicated that whenever entitlement reforms are considered, he expects those to be balanced with additional tax reforms (i.e., spending cuts must be balanced with tax increases).
These factors imply that the next debt limit increase will be at least as difficult to enact as the last one was, and that there is a clear possibility of breaching the limit and causing more significant disruptions to government financing. [ZH: Adding further angst, in the summer of 2011 politicians had started the debate some three months prior to the real deadline. This time it appears that nothing serious will happen until the 11th hour as usual, meaning far more last minute volatility.]
One potentially greater source of uncertainty than in 2013 is the possibility of negative credit ratings actions. Standard & Poor's, Moody's, and Fitch have all indicated that their ratings are contingent on US policymakers agreeing to additional fiscal reforms in 2013 that would stabilize the ratio of public debt to GDP over the medium term. Fitch in particular has also raised the prospect of a downgrade if the debt limit is not raised "in a timely manner." So while we expect that market participants might have become less sensitive to political gyrations in Washington, the possibility of rating agency action could add a new twist to what has started to become an old routine.