Taking Debt Ceiling To The Brink

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As we enter into the second week of the government shutdown, a more ominous threat looms as the U.S. approaches the debt ceiling.  The debt ceiling has always existed as one of the powers of the U.S. Congress in controlling the spending and taxation activities of the government.  Even though the Executive office can create legislation with a President’s signature, Congress can prohibit its funding by imposing a debt limit which limits the U.S. Treasury’s ability to finance current obligations.

We have already reached the debt ceiling, but Treasury Secretary Jack Lew has been able to employ ‘extraordinary measures’ to prevent the U.S. from not being able to pay for funding already authorized by Congressional legislation.  These measures include underinvesting in certain government funds, suspending the sales of nonmarketable debt, and trimming or delaying the auctions of securities.  However, these methods will be exhausted by October 17th.

While it is highly doubtful that not raising the debt ceiling will result in the U.S. defaulting on its interest payments of U.S. Treasuries, there is concern how global investors will react to the potential turmoil inflicted by the U.S. government not paying all of its bills. As stated by Daniel Mitchell of the Cato Institute, the U.S. collects tax revenues exceeding $3 trillion a year, which is more than capable of servicing our U.S. Treasury annual debt service of about $230 billion.  However, it is not sufficient to cover a broad range of government expenditures ranging from national defense, social spending, and transportation.  This disruption in funding could affect credit markets and dampen consumer and business spending that is already hampered by a tepid recovery.

There are a few scenarios that they can pursue, such as either significantly raising taxes or gutting government spending, though either action would have severe consequences to the economy in the short-run.  Federal employees, civilian contractors, educators, and non-profit organizations would all likely feel the negative consequences of dramatic funding cuts.  Unemployed workers and Social Security recipients would also be at risk of delayed payments or benefits.  Another possibility would be the U.S. selling its financial assets to temporarily fund governmental operations, however those options carry legal and practical obstacles.

One must also realize that politically astute moves do not necessarily equate to good economics, especially in the short-term.   In gerrymandered House districts that are highly conservative, there are significant costs to compromising core beliefs.  Voting for a clean continuing resolution that funds the federal government without defunding or delaying the Affordable Care Act are embedded with significant political risks.  Highly financed conservative political action committees will react negatively to any vote that does not impact health care reform and can redirect campaign financing to the opposition in the 2014 primaries.  That places pressure to not compromise and find common ground with the collateral damage being slowed economic growth and higher unemployment.  Though it should be acknowledged that this strategy of self-inflicted wounds to the economy will be worthwhile to some Republicans if it results in sabotaging health care reform or substantive deficit reduction.

On the other hand, Democrats are just as unyielding when considering delaying the individual mandate for a year or waiving the medical device tax.  Both are necessary to generate the revenues necessary to bring down health premium costs that will otherwise rise due to enhanced mandatory health coverage; prohibiting private health insurance companies from denying coverage due to preexisting conditions; and changing demographics that are placing upward pressures on health care services.  That is why Democrats are hesitant to agree to any changes in health care reform that would undercut its effectiveness.

While it appears there is movement within the Senate to extend the debt ceiling to the early part of 2014, that is still a relatively short time frame that compromises business confidence.  Then there is the concern that House Republicans will not see much political benefit in accepting an agreement where Democrats have yielded little in terms of spending cuts or changes to health care reform.  However, the government shutdown would end with funding available until January 15th and there would be an extension of the debt ceiling to mid-February.

If those talks break down, it is not known how financial markets will react.  The worst case scenario would be a dramatic sell-off of U.S. Treasury bonds.  That occurs If global investors are rattled, then credit costs could skyrocket and slow down the rising momentum in U.S. housing, along with compromising future job creation.   The U.S. dollar could plummet and lead to global panic where a deep recession envelopes the globe.  If that occurs, then even a quick resolution among politicians would be too late to minimize damage that could take decades to recover from.

As the clock ticks, the gamesmanship of debt negotiations leaves the global economy teetering on the balance.