The Two Sides of the US Fiscal Impasse

The US Federal government has been forced to shut down non-essential services and furlough around one third of its employees as of 1 October 2013. The partisan infighting in the US Congress means that once again it has failed to pass a formal annual budget, legally requiring a mass shutdown of government services until the spending appropriations bills have been agreed upon and passed. Then there is the other looming fiscal impasse – the debt ceiling. The shutdown is about a deadlocked political budgeting process, regardless of the means of the US Treasury in terms of tax intake or borrowing ability. The debt ceiling is about the ability of the US Treasury to borrow, regardless of a resolution to the budgeting impasse.

The Shutdown

September 30 marks the end of the 2013 Federal fiscal year and Congress, by law, must approve the next annual budget. Due to the Congress being starkly divided politically, no formal annual budget has been passed since 2009. Instead, multiple series of appropriations bills have been contrived through the years, functioning as stop-gap measures.

In the event that a stop-gap measure is not approved, the Federal government will experience a partial shutdown of its non-essential operations until such time as Congress approves appropriations. On this occasion, this will involve about one third of the 2 million-strong Federal workforce being placed on unpaid leave, or what is known as a ‘furlough’.  A partial government shutdown is not unprecedented; they have happened multiple times in the last three decades. In 1995-1996, the government experienced a partial shutdown that lasted for a total of 28 days.

Estimates of the cost of the shutdown are varied, ranging from 0.04 percentage points of GDP a day to 0.10 percentage points of GDP a week, but these kinds of estimates of GDP impact are fraught with conceptual problems. The actual cost will be impossible to quantify as, beyond the overt reductions in expenditure and pay, other disruptions will occur that can affect commerce, such as the processing of regulatory matters, permits, customs and matters of trade. Additionally, regime uncertainty can lead to individuals and businesses deferring expenditure and investment. The furloughing of roughly 800,000 government with unpaid leave could also have considerable effects on consumer markets and household financial stability with around 200,000-300,000 households directly affected and many more impacted through the business impact of diminished spending. Some of this will however be offset by these households accessing credit card debt to supplement monthly budgets and drawing down what little liquid savings they may have on hand. Also, once this impasse is resolved there is the possibility of back-paying federal staff, retrospectively turning their forced unpaid leave into forced paid leave. So consumer markets may well be cushioned by a rise in consumer debt and a fall in household savings, which protects near-term macro data at the expense of somewhat more structural fragility.  However, this shutdown, if it lasts only a few days to a week, should ultimately have a light impact on the system.

The Federal Reserve bank preempted these issues at its September policy meeting, maintaining its ultra-accommodative monetary stimulus policies, in contravention of economist expectations, as a bulwark against the potential fallout in markets due to these fiscal issues, as well as against the negative growth implications. The bigger issue at play that will be riling markets, however, is the coming political battle over the debt ceiling.

The Debt Ceiling

The debt ceiling is a statutory limit on how much the US Treasury is allowed to borrow. This limit of just under $16.7 trillion has already been reached in May, and over the past few months the Treasury has utilized “extraordinary measures” to maintain the government’s Congressionally-authorized spending without needing to borrow additionally. These measures are expected to be exhausted by mid to late October. Timing is imprecise due to the variable nature of revenues, however the Treasury has said its “extraordinary measures” would be exhausted by no later than October 17. While there is still some scope for the Treasury to manage its obligations for a short period thereafter, the situation would become absolutely critical by the beginning of November as the Treasury would then not have the funding means to match its expenditure needs or interest obligations. By the end of November at the least, large interest obligations would almost certainly overwhelm the fiscus. Technically the US would still be solvent in that it could begin to sell non-core Federal assets, but it would certainly be a major liquidity risk and therefore, practically, a default risk.

According to the Bipartisan Policy Center, this inability to borrow would see government spending slashed 32%. In other words, the US government would instantly be forced to run a balanced budget. If European austerity seems draconian, this would be austerity on an unprecedented scale, amounting to the largest fiscal tightening in economic history. Additionally, there could be a complete stop to money supply growth, triggering a major deflation risk, as whole industries and millions of people directly and indirectly cut off from the state’s channels of spending. This would also undoubtedly generate a cascading financial crisis abroad given the impossible-to-understate ramifications of a technical default on the world’s reserve, risk-free assets.

The incentives thus seem sufficiently stacked in favour of resolving political differences on Capitol Hill. In any event, the US has also run up against the debt ceiling many times in the past, with the limit being continuously increased more than 70 times in the last 5 decades. The last time the issue came down to the wire, however, was in 2011 when a deal was only reached hours before the Treasury’s deadline. The political consequences of the 2011 debacle were stark for both political parties, but the Republicans were hurt the most, seeing their approval rating slump from 41% in July 2011 to 33% only a month later. The Republicans will be mindful of this, particularly as next year features the wide scale midterm election wherein all 435 members of the House and over 30 members of the Senate are up for election. Given President Obama’s recent fall in popularity, the Republicans will be looking to capitalise immensely, and this could well see the party establishment reining in their more hard-line, obstructionist lawmakers to prevent another down-to-the-wire encounter that would risk robbing the GOP of the Senate in 2014 and potentially the White House in 2016.

Ultimately, should a worst-case scenario materialize and the debt ceiling not be raised by Congress after mid-October, it is likely the executive branch of the government would simply raise the limit by an emergency presidential decree. Whilst this would be a legally unsound move, the powers that be would likely prefer to face down a localized constitutional crisis rather than the unthinkable domestic and international repercussions should the US come within a hair’s breadth of technical default.

This article is an adapted version of a strategic thematic piece sent to clients of ETM Analytics on September 30.