Deficits and Debt Don’t Matter Do They?

Despite President Obama’s optimistic words yesterday, an eleventh-hour breakthrough in deficit negotiations using the so-called “Gang of Six” plan doesn’t seem to have a chance. The plan, which was resurrected after being discarded earlier in the year, includes an overhaul of the tax code, lower entitlement spending, lower spending on defense and education, and brand new taxes to increase the tax base. Conservative Republicans have already said they would not vote for any bill that includes tax increases, and many Democrats will not stand for cuts to Social Security and Medicare. Is it realistic to think that such massive legislative changes can be agreed upon in the next couple of weeks? Probably not. Moreover, the plan would need to be drafted, studied, and analyzed by the Congressional Budget Office – hurdles that Senator Max Baucus called “practical, procedural difficulties” – before it could be voted on. Therefore, even if politicians were to agree unanimously on the plan, it doesn’t seem like there is enough time before the August 2 drop-dead date for raising the debt ceiling.

A much more likely resolution to the debt ceiling crisis is the McConnell plan, which is being viewed as a “backup plan” for now. The plan is best described below in a CNN.com article published today:

“McConnell’s fallback proposal would give Obama the power to raise the borrowing limit by a total of $2.5 trillion, but also require three congressional votes on the issue before the 2012 general election. Specifically, Obama would be required to submit three requests for debt ceiling hikes — a $700 billion increase and two $900 billion increases. Along with each request, the president would have to submit a list of recommended spending cuts exceeding the debt ceiling increase. The cuts would not need to be enacted in order for the ceiling to rise. Congress would vote on — and presumably pass — “resolutions of disapproval” for each request. Obama would likely veto each resolution. Unless Congress manages to override the president’s vetoes — considered highly unlikely — the debt ceiling would increase. The unusual scheme would allow most Republicans and some more conservative Democrats to vote against any debt ceiling hike while still allowing it to clear.”

The McConnell plan would not represent an agreement or compromise, but rather a loophole in the system. This loophole would allow the President to raise the debt ceiling unilaterally, without a vote from Congress. Furthermore, the raising of the debt ceiling through the McConnell plan would not resolve our budgetary problems. S&P and Moody’s would still be breathing down our necks to address or deficits, and bond vigilantes would be emboldened by yet another failure by the US government to address its profligate spending.

President Obama’s press conference yesterday covering the progress on the Gang of Six proposal acted as a shot in the arm for the capital markets. Stocks were up sharply on hopes of an end to the uncertainty, while bond markets also rallied on hopes that the rating agencies would be placated into backing off their threats. Unfortunately, the Gang of Six proposal is unlikely to either lead to an increase in the debt ceiling or be answer to our deficit problem. McConnell’s backup plan, while possibly serving as the tool to raise the debt ceiling, will also not resolve our debt crisis. Whether we like it or not, this can seems likely to be kicked down the road yet again.

We have long believed and articulated that it may take a crisis to get Congress to do the right thing for the country’s long-term economic health. We are nowhere near that point. While public awareness and voter anxiety over the debt issue have increased, the capital markets are telling Congress that deficits and debt are not a problem. Stocks have held their massive gains off the March 2009 lows, and yields on government bonds are at ridiculously low levels. Even today – thirteen days before we are schedule to breach our debt ceiling and despite warnings from both S&P and Moody’s about a possible downgrade – the yield on the 10-year Treasury note is over 80 basis points lower than the highs for the year. These financial market cues are giving politicians the ammunition they need to delay this problem yet again. If the US Treasury is able to borrow money for ten years for less than 3% interest, where’s the urgency to address the problem?

Obviously, we think the politicians are wrong. Not only do I believe that the failure to raise the debt ceiling would be calamitous, but I also believe that waiting for a crisis to address our debt problem is suicidal. If we are forced into austerity similar to the way the Greeks have been, the pain will increase exponentially. The US may not always be the best house on a bad block for investors, and we would be wise to plan for that day.

Peace,

Michael