U.S. Fiscal Issues: The Debt Limit Debate
On January 24, 2013, Goldman Sachs Research published a report on the debt limit debate in the U.S. Congress, entitled “The US Fiscal Debate: Less to Worry About, But Not Out of the Woods.”
Full Text of the Report
- The fiscal policy choices Congress debates over the next few months will still have implications for markets and economic growth, but the tail risk associated with the debt limit is much lower as a result of the House-passed debt limit extension. While the next extension--probably necessary by August 2013--will still be controversial, the precedent set in the US House this week implies that if lawmakers can't agree on a long-term increase, they will probably at least continue to pass short-term increases.
- But there are still some risks from the fiscal debate. In the near term, Congress needs to address the spending cuts under sequestration scheduled to begin March 1, and to extend spending authority that expires March 27, in order to avert a government shutdown. The risk that Congress fails to deal with one or both of these by the deadline have grown as a result of the debt limit extension. That said, the worst-case outcome on either issue is not nearly as severe as failure to increase the debt limit would be.
- Another round of discussions on entitlement and tax reforms looks likely this year, potentially as part of the debate on budget resolutions the House and Senate are likely to put forth in March or early April, but at this point there is little reason to believe substantial deficit reduction policies will be agreed to beyond what has been enacted to date.
The House has passed legislation which would temporarily suspend the debt limit until May 19 and would probably extend the Treasury's borrowing capacity until sometime in August 2013. Beyond taking the issue off the table in the near term,, the debt limit now appears to pose less risk in the future as well, for two reasons:
- The House bill establishes a precedent. The House bill suspends the debt limit until May 19, and increases the debt limit after that date by the amount of debt issued from the time the bill becomes law (probably around the end of the month). This mechanism is more complicated than prior increases in the debt limit, but it is nevertheless an increase in the debt limit without the commensurate reduction in spending that House Speaker Boehner and other Republican leaders had initially insisted on. Just because they agreed to do so this week, there is no guarantee that congressional Republicans will agree to further extensions without spending cuts. That said, with the precedent now set, Republicans may find that future debt limit deadlines provide them with less leverage than in 2011.
- Even if some House Republicans object to further extensions, they will probably pass anyway. Normally, the House of Representatives passes controversial legislation along mostly party lines, relying on votes from the majority party (i.e., Republicans) to reach the 218 votes needed for passage. This has not been the case in most of the major fiscal debates over the last two years: the 2011 debt limit increase received only 175 Republican votes; in 2012, only 85 Republicans supported the fiscal cliff agreement, and this week's debt limit increase got only 199 Republican votes. Each vote would have failed if Speaker Boehner had relied only on Republican support.
The upshot is that even before this week's action, it had become clear that opposition among some House Republicans would probably not prevent an increase in the debt limit, since Republican leaders would eventually opt to pass a bill with some Democratic support. In prior debates this occurred only after drawn-out negotiations. The action the House took this week reached the same outcome more directly.
There are still two other issues that Congress needs to deal with over the next couple of months:
- Sequestration looks likely to kick in March 1. Spending cuts under sequestration are scheduled to take effect March 1. At this point, the cuts look likely to take effect at least initially, because (1) rather than using the debt limit for political leverage, some lawmakers are instead threatening to allow the cuts to take place unless changes are made in other areas of the budget (Democrats want tax increases, Republicans want entitlement spending cuts), and (2) sequestration is hard to reverse or delay as a standalone effort. When the deadline to address sequestration and the debt limit both fell on or around March 1, it would have been natural to pair these issues together. Now that the debt limit is off the table until later this year, the sequester is left all alone on the calendar. Reversing sequestration is still a priority for many lawmakers, but at this point changes to the sequester are more likely to be made retroactively.
- A government shutdown could occur at least briefly. The temporary spending authority Congress enacted last year expires on March 27. If Congress fails to extend that authority, some federal activities would shut down until funding is restored (roughly 40% of spending is dependent on congressional appropriations and would be affected by a shutdown; of this, about 40% would be deemed non-essential, implying something like 16% of total spending would be affected). To avoid a shutdown, or to restore funding if it is allowed to lapse, Congress must agree on a spending level; it was a disagreement on the basic level of spending that nearly caused a shutdown in April 2011. Legislation to extend spending authority is also the most obvious opportunity Congress will have to modify the cuts under sequestration. If the sequester reversed, Congress would most likely extend spending authority at the current annual rate of $1.047 trillion. If the sequester is implemented in full, spending authority would reflect the sequester by lowering the annual rate to $962bn. The upshot is that extending spending authority will essentially also require lawmakers to reach agreement on the sequester, even if in the end the agreement is simply to let the cuts take effect.
The most likely scenario appears to be that Congress will allow the sequester to take effect from March 1, but that some of the cuts will be addressed retroactively, potentially as part of the process of extending spending authority past March 27. The administration has 120 days to implement the cuts starting March 1, and the Medicare portion of the sequester does not start until April 1, so in theory Congress would have several weeks to act before most of the cuts were implemented.
One option to address the sequester would be to replace some of the cuts scheduled for this year with lower spending caps in FY2014, which starts October 1, 2013. This would allow additional time to phase in the lower spending level, but would result in the same amount of total spending over the next few years. A second option would be to replace the across-the-board cuts under the current sequester with more targeted reductions that would still reduce spending but that would not cause as much disruption when they are implemented.
The congressional budget process is also apt to receive more attention this year than over the last several years. The House-passed debt limit bill would delay the payment of salaries to members of Congress unless their respective chamber passes its annual budget resolution. This has given the Senate a new incentive to pass a budget resolution, which it has not done since 2009 (the resolution of the Bush tax cuts also makes it easier for the Senate to pass a budget this year, since this had been an earlier sticking point).
The budget resolution is not a "budget" per se; the president does not sign it and it does not have the force of law. Instead, it serves as a blueprint for the coming fiscal year, by laying out revenue levels and spending levels by major program. That said, passage of budget resolutions will require House and Senate leaders to be somewhat more specific on their priorities; House Republicans are likely to propose spending cuts greater than last year's budget proposal; Senate Democrats appear to be contemplating a mix of tax increases and spending cuts. While it is hard at this point to envision House and Senate leaders reaching a final bipartisan agreement to resolve the differences between their respective budget proposals, it should nevertheless provide another opportunity for debate on these issues over the next few months. The result may be that, once again, market participants will be watching discussions in Washington for signs of changes to existing tax breaks, important spending programs, or changes to the overall fiscal trajectory.
Legal and Certification Disclosures
Several fiscal deadlines still to come
Source: GS Global ECS Research
Jan Hatzius - Goldman, Sachs & Co.
Alec Phillips - Goldman, Sachs & Co.
Jari Stehn - Goldman, Sachs & Co.
Kris Dawsey - Goldman, Sachs & Co.
David Mericle - Goldman, Sachs & Co.
Shuyan Wu - Goldman, Sachs & Co.
Michael Cahill - Goldman, Sachs & Co.
We, Jan Hatzius, Alec Phillips, Jari Stehn, Kris Dawsey, David Mericle, Shuyan Wu and Michael Cahill, hereby certify that all of the views expressed in this report accurately reflect our personal views, which have not been influenced by considerations of the firm's business or client relationships.
For Reg AC certification, see above. For other important disclosures, go to www.gs.com/research/hedge.html