Debate in D.C. shifting to the debt ceiling

October 4, 2013

The impasse over a government shutdown continues, though the focus of discussion has begun to shift to a more comprehensive package that includes addressing the nation’s debt ceiling, which could be breached as early as October 17. While the budget impasse and the debt ceiling are two different issues, they are increasingly becoming linked as bargaining tools in a broad debate over federal government borrowing and spending in Washington, D.C.

Congress also needs to resolve the next round of sequester-induced cuts, in addition to the debt ceiling and annual budget. In this article, Tim Hopper, TIAA-CREF’s Chief Economist, reviews the most likely outcomes of these three issues and their potential impact on financial markets and future economic growth.

Article Highlights

  • The debt ceiling limit, the federal budget and sequester spending cuts are all issues that likely require resolution in Washington, D.C. by the end of this month to avoid market disruption and economic harm.
  • The debt ceiling remains the largest hurdle, though we believe an agreement will be reached before the U.S. defaults on its debt.
  • The economy will likely grow more slowly over the next two quarters due to the shutdown and a continuation of a slow overall recovery.


The debt ceiling: A nuclear option that no one wants

The debt ceiling ranks at the top of the list of economic importance. Should the U.S. government cease to pay interest on its debt, the ramifications would likely be far-reaching and painful. The U.S. lost its triple-A credit rating in 2011 during the last debate over the debt ceiling, even though an 11th hour agreement was reached. The rating would likely be cut again and future borrowing would include a much higher risk premium in the absence of a credible agreement.

A failure to reach agreement also means Social Security, Medicare/Medicaid, and other pension and healthcare-related payments would be significantly reduced, while education, research and other unrelated government services that would be cut or severed. These events would most likely trigger a recession along with significant financial market upheaval.

However, our view, the chances that this will happen are very small to none. We don’t believe that either side would seriously consider a breach of the debt ceiling because it is a nuclear option — one that benefits no one and hurts everyone.

A shutdown could last several more weeks

The shutdown ranks lower in importance than the debt ceiling debate because it represents a rather benign impact on economic growth, especially in the short run. We estimate a 0.1% direct impact on gross domestic product (GDP) per week of the shutdown and an additional 0.1-0.2% of indirect impact on GDP growth beginning in week two. The indirect impact includes uncertainty of future government action and the impact on business and consumer sentiment and spending.

Sequester cuts: A bargaining chip, not an economic threat

The sequester, the automatic spending cuts adopted by Congress in 2011, is also less economically significant than the debt ceiling debate because it is a known program that is already in place and well-defined. The sequester calls for $85 billion in spending cuts per year through 2021; however, total federal spending is projected to increase by $230 billion (including the sequester) per year during this period, so the net government impact on economic growth will still be positive. It has become another lever in the current spending discussion, but whether it stays or gets cut is a far smaller issue than the debt ceiling.

Most likely outcome: A last-minute deal to avoid a U.S. default

We see the most likely path in Washington as a combination of the shutdown and the debt ceiling debate into one discussion, though one that could linger for several more weeks. The Treasury is expected to hit a $30 billion balance on October 17. However, the next large interest payment and the next large set of Social Security payments are not scheduled until early November, which means there is some potential wiggle room for a deal after October 17 and before then. We expect that Congress will continue posturing until the last possible moment. This means there is time to act before the U.S. defaults on interest payments and other government obligations. Because these two issues are increasingly intertwined, an agreement on the two is more likely to be accomplished at the same time, meaning the shutdown may continue for several more weeks.

The economic fallout

The economy will suffer during this period because, like during the fiscal cliff debate last year, hiring, spending on capital goods and consumer goods will slow and financial markets could become more volatile as headlines rapidly change. A quick agreement on both the debt ceiling and the shutdown, on the other hand, could nudge the economy and markets back onto their pre-crisis growth paths.

TIAA-CREF NEWS ARCHIVE

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