- The European debt crisis has reached a fever pitch and has rattled financial markets.
- Our own budget battle is being played out on CNBC, FOX and other weekly TV news programs, yet little apparent progress is being made.
- The increasing turmoil in Europe should be a warning sign to those in Washington (on both sides of the aisle) that uncertainty undermines investor confidence, and ultimately confidence in the economy.
Earlier this year we wrote “The Budget Battle: Simple But Not Easy” (January 25, 2011), which addressed the challenges on the budget front and focused on our concern about the skyrocketing budget deficits registered over the better part of the last 30 years. At the time we stressed that “many people are playing the political-party blame game… The U.S., like most of developed world, especially southern Europe, has been and is continuing to live beyond its means.” We praised the work of the bipartisan Bowles Simpson Commission on Fiscal Policy Responsibility and Reform and emphasized that Washington officials would be well-served to learn from our neighbors to the north. Today, in late May, we reiterate this message. The budget battle is clearly in full swing and will likely get worse before it gets better.
We still believe that the Bowles-Simpson plan to cut defense spending, raise the social security retirement age, cut the federal workforce by 10 percent, cut farm subsidies, scrap the deduction for mortgages over $500,000, raise gas taxes, lower corporate taxes (but eliminate deductions), raise capital gains and dividend taxes, simplify individual taxes, implement medical malpractice reform, and eliminate Congressional earmarks are bold moves that might just be what our budget process needs. Likewise, the challenges that Canada faced in the 1990’s and countries like Greece, Ireland, Portugal, and Spain are experiencing today represent a very important warning signal that unfortunately many in Washington are not hearing.
As we stressed four months ago and continue to emphasize today, our political leaders will ultimately need to take action to address the runaway freight train on the budget deficit front. The U.S., like most of developed world, especially southern Europe, has been and is continuing to live beyond its means. The latest events in Europe, where Greek debt is worth about 50 percent of its stated value and interest rates in the two-year sector are testing the 25 percent yield area, suggest that the cost of waiting too long to address this issue could be a major problem. Are the Republicans correct that we need to cut spending? Yes. Are the Democrats correct that we need to raise revenue? The answer here is also yes. With a likely $1.5 trillion annual Federal budget shortfall, we can’t dramatically close the budget deficit gap unless we operate on both sides of the ledger.
On May 13th, the U.S. government officially hit its $14.294 trillion debt limit, which means that from now until early August the Treasury will implement portfolio adjustments that it has used in the past under similar circumstances to reduce the amount of nonmarketable debt to make room for marketable debt (the regular issuance of Treasury bills and coupons). Treasury officials have voiced concern that dire consequences will unfold if the debt limit is not passed by August 2nd. However, we strongly believe that August 2nd merely marks the date at which Treasury will have to go beyond the normal conventional measures to avoid breaching the debt limit. Does the debt limit eventually have to be increased? Yes, as the U.S. will have high deficits for several years under all the plans that have been floated in Washington. However, the Treasury could implement several unconventional measures to avoid breaching the debt limit when the monthly social security payments are made in early August. Despite the yellow-journalism tactics, the risk for an outright default on or shortly after August 2nd is extremely low as the Treasury has several actions that it can take to avoid “bankruptcy.”
The challenge with the passage of a new debt limit has been a recurring issue since World War II. In fact, Congress has ultimately approved 78 debt ceiling increases over the last 70 years. Both political parties have often played a high stakes game of poker to deal with the debt limit that has at times included temporary government shutdowns, delayed Treasury auctions, and short-term debt limit increases as a part of the horse trading process. The most extreme case was in late 1995 and early 1996 when the government shut down nonessential services between November 13-19, 1995 and then again between December 15, 1995 and January 6, 1996. Between 1985 and 1995 Congress raised the debt ceiling 17 times, but only seven of the measures were “clean” debt bills. Since 1995 an additional 12 debt limit increases were made; the last increase was for $1.9 trillion on February 12, 2010, which was more than double our nation’s debt for our first 200+ years.
Given the severity of the current debt problems and the intense geopolitical battle in Washington we believe that the debt negotiations will go into overtime. Political rhetoric from both sides has increased in recent weeks with Administration officials touting a “catastrophic economic impact” if the U.S. defaults, while House Speaker Boehner has ruled out any type of tax increase and will only accept a debt limit that is formulated with an equivalent amount of spending cuts. At this point, both political parties appear to be far from the type of agreement that would be necessary to fuel a significant improvement in our nation’s deficit situation. This could create added challenges as today’s low interest rate environment suggests the Treasury market is, in our view, incorrectly priced to perfection. When push comes to shove and we get to the hot humid unbearable August summer days in Washington our political leaders will have an added goal that could trump the budget battle…the desire for a summer recess which is currently slated to begin on August 8th. An extended session of Congress (with temporary short-term debt limit extensions) is possible, but by mid-August we look for a deal to be cut that provides at least a few months of a temporary debt limit that takes us into early next year. However, do we believe this will result in a dramatic long term improvement in our budget deficit situation? Unfortunately, the answer is no.
The debt managers at the Treasury can do several conventional measures to keep the government running until early August. August 2, 2011 does not have to represent D-day for U.S. debt ceiling – it merely marks the day that the Treasury will need to shift from conventional to unconventional measures to avoid breaching the debt limit. First, the Treasury could take a business-like approach and delay several government payments – a wise first choice might be to stop paying Congress until they get a new debt limit and take action to reduce the size of our future budget deficits. As much as we like this as a first step, it probably won’t be implemented. Second, the Treasury could conduct asset sales. Although the selling of a government building or national park would be highly inefficient and expensive, the Treasury has a massive balance sheet that could be used as a source of capital later this year. This includes about $140 billion in TARP equity assets, $400 billion in cash and gold, $100 billion of its MBS portfolio, $160 million in GSE preferred stock, and $300 billion or so in its student loan portfolio. The Treasury will want to avoid expensive “fire sales” but several of the above mentioned programs could be used to prevent a default in early August and give Congress extra days, weeks, or even months to address the budget situation.
A third, somewhat ingenious idea not yet envisioned by policymakers is that the Treasury could convert its non-marketable portfolio to marketable securities. As of May 23, 2011 the government held $4.6 trillion in intra-governmental holdings, including more than $2.6 trillion in social security trust fund assets and $1.3 trillion in government retirement funds. Unfortunately, these two “investment” programs merely represent a paper accounting process of IOU’s from one part of the government to another. However, these non-marketable government IOU securities are included in the calculation of our nation’s debt limit. If the budget talks in Washington break down and Treasury officials want to get creative and finance themselves for several years, they could work on converting these non-marketable securities to marketable securities by selling bills and coupons from the “social security trust fund” rather than the U.S. Treasury. These securities would probably trade at a higher yield (cost) than U.S. Treasuries. Moreover, converting non-marketable to marketable securities could open up the can of worms over the fact that the U.S. Treasury has a run massive unfunded pension fund for the last 30 years as the social security trust fund assets have been spent on other government programs.
What about the Fed helping out the Treasury? Although it may seem a bit odd, the Fed can’t directly use its $2.7+ trillion portfolio to rescue the Treasury as the Fed is not allowed to lend money to the U.S. Treasury. However, the Fed can and does remit excess profits to the Treasury. Given the Fed’s massive holdings, it is technically possible that the Fed could accelerate the monetization of its holdings and send a solid portion of this year’s profits “early” to provide liquid assets to the government.
We would love to see a real budget deficit-cutting plan that includes a significant cut in spending and a broadening in the tax base that raises revenue. Unfortunately, such action at this juncture is highly unlikely. Given the low level of market interest rates, our Washington leaders have not gotten the real message of how challenging a situation we truly have on the deficit front. However, the events that are unfolding in Europe, specifically Greece, represent an important warning signal that the bond market vigilantes could move to the U.S. in quick fashion if our leaders don’t get serious on the debt situation. The mud-slinging between Democrats and Republicans is likely to get uglier as the weather gets hotter this summer in Washington. However, having lived through the budget battles of the 1980s and 1990s, I have no doubt that our political leaders will put on a show that can be used for the 2012 election battle, but by mid August either a temporary deal will be cut to expand the debt limit or Treasury officials will suddenly become creative and implement some of the measures discussed above. Yes, the budget battle continues---simple but not easy.
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