A failure to raise the US debt limit would cause a deep recession and unnecessarily hurt US credibility. In general, however, political pressure from fiscal conservatives hasn’t hurt the US – in fact, it may have helped the US return to the path toward a balanced budget. ...
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Mikio Kumada, Global Strategist at LGT Capital Management
Thanks to a sufficiently robust economy, US revenue has been rising steadily since 2010, while spending began to fall modestly in early 2012, leading to an accelerated decline in the budget deficit.
Not raising the debt ceiling would be potentially disastrous
Over the past few weeks, global financial market activity has to a large degree been overshadowed by the continued partisan divide in the United States over the country’s fiscal and health care policy. Not a day passes without some national and international personality appealing to US policy makers to work out an agreement and raise the debt ceiling in time (presumably by 17 October). A failure to do so would force the US federal government to make large, abrupt spending cuts, which could in turn raise the risk of delayed interest and/or principal payments to holders of US treasury debt. The latter could be catastrophic for the financial markets because it would technically constitute a debt default by the world’s biggest economy and main reserve currency issuer.
A fiscal policy compromise is emerging
This nightmare scenario is unlikely to unfold in our view. The latest news reports suggest Congress negotiators are moving closer to agreeing on a compromise formula and raise the ceiling enough to allow the treasury to fund government expenditures in full for several months. But even with the agreement, the possibility of similar policy disputes would not be completely off the table. In principle, the debt ceiling issue has not been a political problem for decades. In fact, since 1960, Congress has raised it every eight months on average, without too much ado (and it was raised more often under Republican presidents). In more recent years, however, a significant segment of the Republican Party is fiercely resisting President Barack Obama’s deficit-spending in general and an already legislated expansion of the US health care system in particular.
Pressure in favor of balanced budgets is likely to remain
As long as this political segment is sufficiently represented in Congress, we should continue to expect similar legislative tactics and political confrontations in the future. Such partisan maneuvers can be noisy and disturbing but the process ultimately aims at bringing US government spending more in line with revenue. Of course, in principle, a balanced budget is a good thing to aim for, particularly if done in a manner that isn’t counterproductive for all involved parties. However, in the extreme and unlikely case that Congress fails to raise the debt ceiling, the federal government would be forced to immediately cut expenditures down to its level of revenue, which would amount to a sudden cut in public spending by more than 4% of gross domestic product in the first year. Such an austerity shock would be bound to plunge the US into a deep recession.
Compulsory saving would cause recession
Thus, the greatest risk at present is not the possibility of a technical bankruptcy, but a relapse into a severe recession resulting from a self-imposed austerity in the US. In view of the improving US fiscal situation in the past few years, such an extreme course of action would make very little economic sense, and probably ultimately also lack a majority within the Republican Party. The US budget deficit, while still high, has been declining steadily since 2010 – and the pace of that decline has picked up remarkably since early 2012. Derailing this welcome fiscal trend out of loyalty toward a relatively small and radical political group could be seen by many US creditors as irresponsible, and prove politically damaging in the end. Even a very short delay in any US interest payment could significantly degrade the perception of US creditworthiness globally, which is another reason Congress is likely to work out a solution. In general, however, the political pressure in favor of a more balanced US budget is certainly acceptable and reasonable. More importantly, it can also have positive side effects – as US fiscal developments since 2012 already suggest.
US federal government is on the fiscal recovery path
We use the moving averages to highlight the underlying trend as the actual monthly values can fluctuate wildly from month to month, due to seasonal and other reasons, clouding the big picture. At present, the US treasury takes in around $220 billion per month, with the trend clearly rising again since 2010. Expenditure stands at about $300 billion per month on average, with the trend moving broadly sideways since 2009 and moderately decreasing since 2012. Rising revenue, combined with a high but stable to slightly declining level of expenditures has led to a relatively fast decline of the budget deficit from around 10% of gross domestic product in 2009 to about 4.2% at present.
US federal deficit is retreating at an accelerated pace since 2012
The government’s net interest payments, meanwhile, make up an average of only $21 billion per month, or a little less than 10% of average revenue. The US can certainly afford its debt, even if we include principal repayments. In addition, the US constitution clarifies that the US must honor its debts. Thus, if Congress decides not to raise the debt ceiling, the administration will have to undertake sharp spending cuts in discretionary and other spending items. In the current situation, that would eliminate about $80 billion from flowing into the economy per months – an amount that would almost certainly cause a recession. In addition, the positive trend towards a balanced budget would most probably be interrupted, as state revenues would at first decline even faster than spending because of the recession. That would in turn lead to a deteriorating fiscal situation and increase the budget deficit again.
Source: ETFWorld – LGT Capital Management
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