Market participants breathed a sigh of relief after the US Congress passed the American Taxpayer Relief Act, extending most of the Bush tax cuts and limiting (but not eliminating) the fiscal drag on the economy in 2013.
While we share that relief, we remain very concerned over unresolved fiscal policy and budget issues that will likely come to a head by March.
Debt Ceiling (Late February-Early March)
Legislation sets a maximum cap (currently US$16.394 trillion) on the amount of debt the Treasury Department can issue. If the level of outstanding debt reaches that cap, the Treasury Secretary can carry out several extraordinary measures to “buy time” so that Congress can pass ceiling-lifting legislation.
Such methods were previously used in 1996, 2002, 2003, 2004, 2006, 2007 and 2011. In a letter to members of Congress dated December 26, 2012, Treasury Secretary Tim Geithner indicated that the ceiling would be reached on December 31st and that he was once again employing these measures.
Unfortunately, these maneuvers can buy only a limited amount of time. Mr. Geithner indicated that the actions would generate about US$200 billion of “room” under the debt ceiling, and the Bipartisan Policy Center’s estimate is that this room will be exhausted between February 15th and March 1st.
Beyond this point, the debt ceiling would become binding, forcing the President/Treasury Department to choose among a menu of extremely unpalatable options that generally fall into one of two categories: working within the confines of the debt ceiling, or simply evading it. Given that the debt ceiling has always been increased when required in the past, either path would be completely unprecedented.
If the Executive Branch decides to operate within the confines of the debt ceiling, one course of action would be “payment prioritization,” where the government pays some obligations but not others. The inability to issue additional debt beyond the ceiling would force the government to live hand-to-mouth, relying on current revenue inflows to finance outlays.
Unfortunately, revenues in the February/March period tend to be among the lowest of the year and would be inadequate to cover all outlays. Indeed, according to the Bipartisan Policy Center, for the February 15 to March 15 period, after paying interest on debt, government revenue inflows would cover less than 60% of the likely remaining outlays.
In other words, Treasury could pay interest on debt, send out IRS tax refunds to individuals, pay military salaries and retirement benefits as well as other entitlements (Social Security, Medicare, Medicaid), but little else. Other outlays (such as unemployment insurance, veteran benefits, salaries and benefits for federal employees, the Department of Justice, air traffic control, and payments to defense vendors) would need to be delayed.
The sharp cutbacks in spending that would be required if the government were forced to live hand-to-mouth (i.e. spending only the revenues taken in) for an extended period of time would be substantial.
Indeed, based on the Office of Management and Budget’s forecasts for revenues and outlays, the cuts in spending required for the government to run a balanced budget (thereby staying below the debt ceiling) through the end 2013 would total over 5% of GDP, tipping the United States economy into a deep recession.
Aside the economic consequences associated with the government being forced to live hand-to-mouth, such an endeavor would face other hurdles. The Treasury Department stated in 2011 that it believed it had no legal authority to prioritize some payments over others, and such action would likely face legal challenges from those whose payments are withheld.
Even if payment prioritization were to pass the legal hurdle, it may be logistically strenuous: the Treasury Department processes 100 million payments per month, and it may be impossible to modify government computer systems in time to put a payment prioritization system into place.
The practical, economic, and political problems associated with operating under the debt ceiling have led policy wonks to explore other options which involve effectively evading or ignoring the debt ceiling.
Platinum Coin, Other Options
One suggestion has been to invoke the 14th Amendment. This amendment to the US Constitution, adopted in 1868 during the aftermath of the US Civil War and pertaining primarily to the rights of African Americans after abolition of slavery, also states that “The validity of the public debt of the United States, authorized by law… shall not be questioned.”
Given that honoring the debt ceiling would potentially risk default on principal or interest on US government debt (if revenues at any point are insufficient to make a debt payment), some have interpreted this Amendment as giving the President license to ignore the ceiling. While this option has generated some chatter among market participants, it is important to note that the White House has repeatedly stated that it does not believe it has legal authority to use the 14th Amendment to ignore the debt ceiling.
Another possibility that has garnered some attention is the “platinum coin option.” While legislation limits the amount of coinage that the Executive Branch can mint out of other metals, no such limit exists for platinum. In other words, the Treasury could mint a very large denomination platinum coin (for example, US$1 trillion), deposit the coin in Treasury’s account at the Fed, and use the proceeds to fund government outlays over and above the revenues that are taken in.
Presumably the Fed would sterilize the impact of the platinum coin on the money supply by selling assets on its balance sheet (thereby mitigating the risk of future inflation), though investors would likely have much bigger concerns than inflation if Treasury chooses to go down this path.
A third option would be for the government to pay some intended recipients of government outlays with IOUs rather than cash. In many ways, this option resembles (and runs into the same logistical and legal problems as) payment prioritization. Indeed, all of these options would likely trigger legal challenges and quite possibly trigger a constitutional crisis. As a result, we view them as extremely unlikely.
The Sequester (March 1)
The American Taxpayer Relief Act signed during the beginning of January blocked most of the tax increases slated to take effect in 2013, but punted on spending cuts. In particular, US$109 billion in across-the-board, uniform-percentage cuts known as sequestration were delayed for two months and are now due to take effect on March 1st.
Previously, we had assumed that a desire by both parties to avoid cuts to their favorite programs would result in a delay or mitigation of these cuts. However, recent comments by House Majority Leader John Boehner have indicated that his party is now willing to allow the defense spending cuts to take effect.
The Congressional Budget Office estimates that the decline in actual government spending that would likely be seen under sequestration are smaller than often discussed, because the drop to actual budget outlays during 2013 (as opposed to budget resources) would total US$58 billion. We estimate that sequestration (as currently mandated) would shave less than half a percentage point from 2013 real GDP growth – an unpleasant, but not catastrophic, outcome.
Continuing Resolution (March 27)
The third looming fiscal issue facing US policymakers in the next few months is the forthcoming expiration of the temporary legislation currently funding the government. Traditionally, Congress has funded the government using annual budgets. However, the last budget was passed in 2009 and, since then, the government has been funded by a sequence of continuing resolutions, the most recent of which is due to expire on March 27th.
If no budget or continuing resolution is approved by that date, the government will experience a “partial shutdown.” It is important to differentiate such a situation from the more severe crisis that would ensue under payment prioritization, because many essential government functions would continue under a partial shutdown: national security, emergency and disaster assistance, medical care and air traffic control would all carry on.
Treasury would continue to issue debt, essential government workers would remain at their desks, and Social Security checks would continue to go out. The Federal Reserve, which does not rely on government funding, would continue to operate unimpeded.
However, such a shutdown would still have real and potentially significant consequences. Non-essential government workers would be furloughed (not collecting paychecks) and many private-sector contractors with the government would not be paid (potentially triggering layoffs at those companies).
Non-essential government functions, such as running national parks and processing visas and passports, would grind to a halt. Many government offices would run on reduced staff, and some functions such as IRS tax refunds and data releases would be delayed. The longer the shutdown continued, the more damaging it would be to economic activity.
The most recent example of an extended partial shutdown of the government occurred in late 1995 and early 1996 – five days in November and then another 21 days in late December and early January. The November shutdown led to the furlough of 800,000 government workers. There were also spillover effects on other sectors of the economy, including:
- The closure of 368 National Park Service sites that resulted in a loss of 7 million visitors, with localities near the parks losing US$14.2 million per day in tourism revenues; closure of national monuments and museums (loss of 2 million visitors)
- 200,000 US applications for passports went unprocessed while 20,000-30,000 applications for US visas went unprocessed, resulting in millions of dollars of losses to airlines and tourist industries
- US$3.7 billion out of US$18 billion in federal contracts were impacted
- Work on 3,500 bankruptcy cases was suspended; the hiring of 400 border patrol agents was cancelled; delinquent child-support cases were suspended
The ripple effects from a shutdown created a drag on certain sectors of the economy. Overall, the Congressional Budget Office estimated that the shutdown over the three weeks in the fourth quarter subtracted about 0.5 percentage points off of growth in that quarter. Given this, a one- week shutdown now might reasonably be expected to shave a couple tenths of a percentage point off growth.
Of course, economic activity will be boosted by the resumption of government spending once funding is approved. Thus, if the shutdown is brief, the net impact on quarterly real GDP growth would likely be negligible.
Nasty March Cocktail
The TARP vote of 2008, the debt ceiling crisis of 2011, and most recently the fiscal cliff negotiations all shared a common theme: US policymakers ultimately acted to avert self- inflicted disaster, but only at the very last minute.
Each of the prior situations involved frantic, behind-closed-doors negotiation, public political grandstanding, failed near-deals, and seeming impasses. In all likelihood, this process will be repeated when the 2013 fiscal issues come to a head in February and March.
Before then, it is likely we will see attempts by both parties to draw lines in the sand and to fight for public opinion in order to strengthen their bargaining hand. We will pay particularly close attention to President Barack Obama’s inauguration speech (January 21) and State of the Union Address (February 12).
The latter has historically been used to push the President’s policy agenda and Mr. Obama may view it as an ideal opportunity to turn up the political heat on Republicans. The tone of his speech will provide further insight as to how rancorous the upcoming budget battles will be.
About the Author
This article is excerpted from “U.S. Economics Weekly," a report by Royal Bank of Scotland and affiliated companies that was published on 11 January 2012. It has been re-edited for conciseness and clarity.
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