Economic News & Analysis—January 8, 2013
Political battles on the horizonBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
If you think the New Year’s Day battle over taxes was the end of the political skirmishes, think again. The “American Taxpayer Relief Act of 2012” was misnamed since it didn’t give many—if any—taxpayers much relief. Payroll taxes went up. Income and capital gains tax rates went up for individuals making more than $400,000 per year. Exemptions and deductions were subject to phase-outs for those making more than $250,000 per year, increasing their effective tax rates. There were numerous taxes related to the Affordable Care Act that went into effect. Instead of relief, we may have gotten a bit of indigestion.
There were some positive things in the Taxpayer Relief Act: keeping income and capital gains tax rates where they were for the majority of Americans and indexing the alternative minimum tax (AMT) exemption and the estate tax exemption to inflation so they don’t have to be “fixed” every year were pluses. The bonus depreciation given to businesses was also a plus, since it will help businesses (job-creators) to expand their businesses. Doctors who see Medicare patients won’t have their reimbursements cut by 26.5%. There is also the wonderful fact that milk prices won’t possibly skyrocket, since the Department of Agriculture won’t have to step in to buy up milk at ridiculously inflated prices.
Brace for a toxic February and MarchThe sequester, the debt ceiling, and the threat of a federal government shutdown loom. Now we’re left with the prospect of a politically toxic late February and early March. The spending cuts that were supposed to kick in on January 2, 2013, (the sequester) have been delayed to March 1, 2013. The federal government hit the debt ceiling on December 31, 2012, and it may need to be raised in late February or early March. The government has been operating without a budget and has instead been financed through a series of “continuing resolutions”; the latest one expires on March 27, 2013. The spending cuts, the debt ceiling, and federal government funding are all things that could create more drama in D.C.
The sequester: The next step on the fiscal staircaseThe spending cuts that were part of the fiscal cliff are postponed to March 1, 2013. These cuts came from the deal struck in August 2011 as part of the Budget Control Act (BCA). The BCA called for the formation of a deficit cutting committee known as the “Super Committee,” which was supposed to come up with spending cuts. Failure to come to an agreement would result in an automatic “sequester” of $1.2 trillion to kick in on January 2, 2013. The default cuts were to be shared equally between defense and non-discretionary programs, meaning that Social Security, Medicare, and Medicaid would be spared from any automatic cuts.
When the Super Committee was formed, I argued that it was doomed to fail because entitlements weren’t on the table, and some Republicans were okay with the defense spending cuts that the many other Republicans in Congress wouldn’t support. Indeed, the Super Committee failed. As a result, we had the spending cuts scheduled to start in 2013. Just to put the spending cuts into perspective, the $1.2 trillion is spread out over 10 years. The 2013 cuts would amount to about $110 billion, which is a drop in the bucket compared to the over $3.5 trillion federal budget. Certainly, the cuts could hurt certain programs and companies, but they wouldn’t likely have much broader impact to the economy.
With the deal struck in the House and the Senate, the fiscal cliff was converted into a fiscal staircase, and only some of the feared tax increases went into effect. The spending cuts make up the rest of the fiscal cliff.
Now that the sequester has been postponed to March 1, 2013, how might it play out? Thinking about it strategically, I find it difficult to believe that President Obama has much to lose in the negotiations. It’s mainly the conservative Republicans in Congress—and not the more Tea Party–oriented Republicans—who decry the cuts to defense. But what do the Republicans have to offer the president to forestall or avoid the defense cuts? Perhaps the Republicans will need to put the debt ceiling on the table.
The debt ceiling: The carrot the Republicans can offer the presidentThe debt ceiling is a congressionally imposed limit on the amount of debt the federal government can issue. The U.S. Treasury reported that the government hit the debt ceiling already, but it can take extraordinary measures before it will become necessary to issue more debt.
There is a lot of misunderstanding about what could happen if Congress doesn’t raise the debt ceiling. Some people have claimed that the U.S. government could default on its debt if the debt ceiling isn’t raised. That is false.
The debt ceiling was created in 1917 through the Second Liberty Bond Act. Originally, it was a matter of convenience, since Congress had to approve every issue of debt, not just how much to issue, but also the terms of the debt (coupon payment and maturity). That was a hassle, so Congress outsourced this responsibility to the U.S. Treasury—part of the executive branch of the government.
Congress didn’t want to give up complete control, so the law said that the Treasury could issue debt up to a certain amount, but no more than that amount. Almost all government debt is subject to the debt ceiling, though there is a small fraction that isn’t. The limit on debt is called the “debt limit,” or the “debt ceiling.”
What happens when the debt hits the ceiling?When the amount of debt outstanding hits the limit, the U.S. Treasury can use certain accounting tricks to postpone the need to issue more. But when it exhausts these options, the government operates on a “cash flow basis,” which means that before it can make disbursements, it needs money in the bank to cover them. Effectively, the Treasury needs to prioritize payments. To conserve cash, the government could shut down nonessential operations. If necessary, the government might even need to postpone payments on Social Security, Medicare, and Medicaid. One thing the government would not need to do, I contend, is forgo making interest payments on the debt. The cash the government collects on a regular basis is more than enough to make interest payments on the debt.
In the worst-case scenario, if the cash collected isn’t enough to pay the interest, the president could—or, I would argue, must—issue more debt to cover the interest payments. Section 4 of the 14th Amendment of the U.S. Constitution states that, “The validity of the public debt of the United States…shall not be questioned.” The President of the United States has said that this does not authorize him to raise the debt ceiling on his own, and he’s right. However, it does authorize him to ignore the debt ceiling if the alternative would be to default on the U.S. government’s debt. In fact, in 1935, the U.S. Supreme Court said as much in Perry v. United States. Additionally, Section 3123 of Title 31 of the United States Code specifies that the Treasury must pay interest on the debt.
Despite its problems, the debt limit does serve a purposeThe debt limit does serve as a useful tool, though. One session of Congress cannot bind future sessions. Thus, the debt limit serves as a back door to undo past political promises. For example, if one session of Congress creates a program that is intended to create a stream of government payments into the distant future, rather than voting to abolish the previously passed legislation, Congress can say it won’t make the payments. Perhaps it’s a cowardly way to undo previous political promises, since it would put the onus—and perhaps blame—on the executive branch, which needs to prioritize payments, but lack of bravery doesn’t seem to be much of a political liability. Rather, the ability to deflect blame seems to be a real virtue.
While it’s true that the U.S. government would likely need to do things like furlough federal employees and possibly not make payments on other things—like postponing payments to contractors, shutting down national parks, and possibly skipping entitlement payments—an actual default is a near impossibility.
Ignore the threat of default—it’s just noiseDefault refers to a situation when the government doesn’t meet its payments on its debts. Political promises, like Social Security payments, are not debts. Only if the U.S. government didn’t make an interest payment, or failed to roll over a debt issue, would the government be “in default.” When a government issues debt denominated in its own currency—like the U.S. government has done—there is no need for default.
A technical default has already happened. In 1979, the U.S. government failed to make payment on a few hundred million dollars in Treasury bills because the printers broke. The default occurred, not because the government didn’t have the money, but because of a technical failure. Borrowing costs did go up a bit, but it wasn’t a massive increase.
Yes, politicians will threaten default. They will point to “the other side” and say that if there isn’t a compromise there may be a default. They are bluffing. It is pure posturing.
But what if the U.S. government’s credit rating gets downgraded?Credit rating agencies have threatened to downgrade the government’s debt. To that, I say, “So what?”
First, the U.S. government’s credit rating has already been downgraded. On August 5, 2011, S&P downgraded the U.S. government’s credit rating to AA+ from AAA. Immediately afterward, the 10-year Treasury yield went from 2.56% down to 2.32%. Yes, the interest rate went down, not up.
Second, other credit rating agencies have downgraded the U.S. government’s credit rating. There are three big credit rating agencies that get a lot of media attention (S&P, Fitch, and Moody’s), but they aren’t the only ones. Some of the smaller credit rating agencies have already downgraded the government’s debt.
Third, there almost certainly wouldn’t be a flight from U.S. Treasuries by investors. Every prospectus and investment mandate that I’ve looked at defines U.S. Treasury debt as being “investment grade,” regardless of what credit rating agencies say. Even if multiple credit rating agencies downgrade the U.S. government’s debt, nobody needs to listen. It’s unlikely that there would be a major sell-off of government debt. It’s unlikely that the U.S. government’s debt would be downgraded to “junk” status. It likely would still stay investment grade. Even if it isn’t viewed as investment grade, U.S. laws related to the regulation of banks and money markets define the U.S. government’s debt as being acceptable to hold. If anything, the Federal Reserve would step in, or perhaps force banks to step in, to support the Treasury market.
Another threat of government shutdownThe final issue to look for in March is the debate around the “continuing resolution” that is funding the U.S. government. Congress hasn’t passed a budget in four years, so it’s been passing resolutions to keep programs running. These continuing resolutions provide budgetary authority for federal agencies and programs to continue operations until regular appropriations can be enacted.
If a budget isn’t passed, or another continuing resolution agreed to, by March 27, federal agencies and programs—except essential services and functions—would need to stop. Spared would be defense, Social Security payments, Medicare and Medicaid payments, air traffic control, law enforcement, borrowing and tax collection, and other items on the list maintained by the Office of Management and Budget. Shutdowns happened both in 1995 and 1996. One was threatened in 2011. A shutdown certainly affects some individuals, but it’s not something that would have major economy-wide implications.
Ignore the hype while looking for opportunitiesThere are three looming issues investors might want to watch: the sequester, the debt ceiling, and the expiration of the continuing resolution. These will all come to a head in February or March. I think the Republicans will need to tie these all together in a negotiation with the president if they want to push for entitlement reform. Dealing with these issues in a one-off fashion, I think, puts the president in the position of power in the negotiations. Considering that the president has said he’d like not to argue, he might be inclined to agree to the formation of a bipartisan committee to propose tax and spending reforms in exchange for an increase in the debt ceiling and continued budgetary authority.
Regardless of what happens in the upcoming negotiations, I wouldn’t get caught up in the hype around words like “sequester,” “default,” and “shutdown.” If others get caught up in the excitement and drama, that could create opportunities to buy assets when they go on sale, or sell assets that are trading with a fear premium built in.