Taxing Times: Now that we’ve hit the debt ceiling, what’s next?

U.S. Gross Public Debt 1900-2016

Current estimates of US government debt to gross domestic product are at 120% for 2011, a level last seen in 1947. Refer to www.usgovernmentspending.com for more information.

On May 16th, the US Treasury reached its debt limit of $14.3 Trillion dollars.1 While the Treasury has room to maneuver for a few months, the situation could become critical if Congress fails to authorize a higher borrowing capacity by this August.

Sources currently estimate that the U.S. government could continue to function normally until August 3rd using various financial tactics to forestall an outright default on debt payments. After that, the lack of an increased debt capacity could threaten daily government functions such as salary payment, social security checks, and military funding. Moreover, unintended consequences could be incurred in the form of:

  1. Higher interest rates, which could slow growth
  2. Default threat, though unlikely, which could rattle the financial markets

Bottom line
Expect that an increased debt authorization will happen in the nick of time as has happened routinely in the past. Until then, “headline risk” may be high. Also expect increasing rhetoric to infuse the authorization debate and anticipate that each party will demand concessions from opponents in the form of tax and expenditure policy changes.

A little bit of history

Since 1960, Congress has authorized an increase to the debt limit 78 separate times. According to the Treasury, the authorization has occurred “49 times under Republican presidents and 29 times under Democratic Presidents.”2 It is difficult to predict votes of individual members of Congress simply by extrapolating their past voting records. According to Bloomberg, “When it comes to the debt limit, virtually every member of the U.S. Congress is a flip-flopper.” Sometimes the debt limit increases come with additional legislative agreements, sometimes not.

Is it different this time?

In terms of rhetoric, this authorization is more contentious than most. In exchange for their support, Republicans are threatening to require substantial spending cuts in the 2012 Federal budget (to date there is not a 2011 budget). The most vocal of the group demand that Democrats agree not to raise taxes. In contrast, Democrats generally prefer to maintain spending and to raise taxes on income levels above $250,000.

Potential for negative outcomes

The immediate effect of raising the debt ceiling helps the US government meet ongoing obligations when the deficit is expected to be almost 11% of GDP for 2011.3 Long term worries highlight the potential for interest rates to rise if deficits continue to accrue long term. On April 18th Standard & Poor’s rating agency affirmed its AAA rating of US debt. However, Standard & Poor’s states that due to “what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable.” They also note that there is “a material risk that U.S. policy makers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.”

Potential for positive outcomes

Amidst the varied plans to address the budget deficit and debt over the next ten years, a bipartisan group of Senators, dubbed the “Gang of Six,” had been negotiating to create a workable plan. Now a “Gang of Five,” the group has attracted headlines for those hoping that a middle road to solving the debt overhang could be achieved. The group continues to grapple with many of those same issues discussed in the “Moment of Truth Report” authored by Obama’s appointed Commission on Fiscal Responsibility and Reform. If Congress and the President can create a strategy to meaningfully narrow the debt over time, negative outcomes in the form of high interest rates or default threat may be avoided.

What the market is saying

Despite the harsh headlines and long term worries about US debt, the bond market seems sanguine that an agreement to raise the debt limit will happen as a matter of course. Note that a higher debt ceiling merely provides more time for politicians to negotiate the painful cuts in services and higher taxes that seem inevitable given gross public debt. We expect that the US government will continue to function and that the treasury market, which is the most liquid in the world, will remain the safe haven in the near term.

Abigail Huffman, CFA, is the director of research for Russell Investments’ investment strategies group.

1Refer to www.treasury.gov for further information.

2Refer to www.treasury.gov for further information.

3“Debt-ceiling vote breeds flip-floppers as Lawmakers Eye Deadline” by Julie Hirschfield Davis, May 16, 2011.

RFS-12120-e

Tags:

  1. No comments yet.

Current day month ye@r *

Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments 2014. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Financial Services, Inc., member FINRA (www.finra.org), part of Russell Investments.