An Unnecessary Crisis

With the lapse in appropriations, the federal government slipped into a partial shutdown last week. The economic impact will depend on how long the standoff lasts, which could be a couple of weeks or more. Recent economic data suggest that third quarter growth was a lot lower than anticipated. So, the crisis in Washington arrives at a particularly bad time. Lawmakers appear to be taking the debt ceiling more seriously, and we could see action on that before the budget authorization is settled – but it’s unclear how the situation will be resolved.

Recall that there are two issues here: the government’s spending authority (the budget) and the borrowing authority (the debt ceiling). The Continuing Resolution that funded the government expired at the end of the fiscal year (September 30). Without a renewed spending authorization (another Continuing Resolution), the government has entered a partial shutdown. Most critical areas of the government remain in operation, but spending cuts are being felt across the country. Some 800,000 federal workers have been furloughed and about two million are working without pay (note that Congress typically agrees to settle back pay when these things are resolved). Private contracts with the government are also affected (it’s estimated that the 1995-96 shutdown hit about 20% of government contracts). The incomes of government workers and private contractors will be more distorted the longer the shutdown lasts. In addition, many firms may put off new hiring and capital expenditures amid the uncertainty.

The debt ceiling is a much bigger issue for the economy and the financial markets. A default in government debt would set off a chain reaction in the fixed income markets. Financial firms have no way to deal with Treasury securities in default. Already, the threat of default has led to some weakening in the dollar and a pop in four-week Treasury bill yields (reflecting some probability that these bills will not be paid off in time).

Will the government default? Almost certainly not. President Obama has three choices here: 1) ignore the debt ceiling; 2) issue a $1 trillion platinum coin; 3) prioritize debt spending to meet interest and redemption obligations.

Option 1 – Can the president legally ignore the debt ceiling? Constitutional scholars are divided. The 14thamendment reads “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” Applying that to the debt ceiling seems a stretch. However, the real issue is that the borrowing and spending authorities are in conflict. Through the budget, Congress tells the president what to spend. The debt ceiling merely allows the president to honor spending obligations.

Option 2: The law currently allows the Treasury to mint commemorative coins. It could, theoretically, mint a $1 trillion coin, deposit that at the Federal Reserve, then spend against that account, dodging the debt ceiling. There would be nothing illegal about this, but we’re unlikely to see it in practice.

Option 3: The government could spend only what it takes in. Spending would have to be prioritized. Interest payments and redemption of existing securities would be met – no default. However, about 40% of government spending would come to halt. That’s about 7% of GDP, a more rapid rate of decline than was seen during the Great Depression.

During the 2011 showdown on the debt ceiling, then-Treasury Secretary Geithner ruled out all three options. If push comes to shove, and the debt ceiling isn’t raised, we’re almost certain to see option 1. There could be a legal challenge, after the fact, which could go to the Supreme Court, which would likely resolve the situation by ruling the debt ceiling invalid.

How did we get to the current dilemma? It wasn’t by chance. Republican leaders had suggested early on that a budget and debt crisis would be a strategy to defund the Affordable Care Act. Eighteen times, Senate Democrats requested a conference with the House Republicans on a budget for the full fiscal year, and 18 times, the House Republicans refused. More recently, the House Republicans requested a conference with the Senate Democrats on a short-term Continuing Resolution, but were turned down. Senate Democrats are never going to repeal or delay Obamacare. Hence, the standoff appears to be futile for the Republicans. Yet, it may be in their interest to fight. Of the 232 Republicans in the House, about 20 are hardcore Tea Party members and another 30 have strong ties. However, that minority has considerable power. In adopting a more conservative stance, they have a greater chance of re-election.

How will this be resolved? Note that Hurricane Sandy relief, the fiscal cliff deal, and the Violence Against Women Act did not progress through the House. In fact, most House Republicans voted against these bills. For each of them, a deal had to be worked out in the Senate with the view that it could be passed by a majority of the House (not a majority of House Republicans). The Speaker of the House would then have to agree to put that to a vote on the floor of the House. That’s counter to the Hastert Rule (more of a guideline than a hard rule), which requires a bill to have support of the majority of the majority to reach the House floor. So, the key here is John Boehner. Mr. Boehner indicated last week that he would not allow the U.S. to default on its debt.

Meanwhile, the nonsense in Washington isn’t going to help an economy that has shown signs of slowing in 3Q13.

© Raymond James

www.raymondjames.com

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