The U.S. Federal government hit its statutory debt limit on January 19, prompting the implementation of extraordinary measures to prevent a default on U.S. government debt. Few policy issues in Washington have such destructive capacity and such far-reaching implications.
On this episode of TD Cowen’s Thematic Outlook Podcast, Chris Kreuger, TD Cowen Washington Research Group Analyst for Macro, Trade, and Fiscal & Tax Policy, joins Bill Bird, Head of Thematic Content. Chris offers insight into what’s different now vs. prior negotiations, how the battle could play out, and what he is watching to gauge progress toward an agreement.
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Unfortunately, the setup is arguably worse than 2011.
The topic of today’s episode is the U.S. debt ceiling. On January 19th, the U.S. reached its statutory debt limit and extraordinary measures to avoid a default on U.S. government debt are underway. There are very few policy issues in Washington with such destructive capacity and such far-reaching implications to both global markets and U.S. leadership. Yet we find ourselves at the brink of yet another crisis with Republicans demanding spending cuts in return for debt ceiling relief.
My name is Bill Bird, Head of Thematic Content. And to help us unpack this topic, our guest today is Cowen Washington Research analyst, Chris Krueger. Chris covers macro trade, fiscal and tax policy for Cowen Washington Research Group. Chris, welcome and thanks for joining us today.
Thanks, Bill. Great to be back with you.
Chris, this isn’t your first rodeo. You’ve followed a number of debt limit battles over the years. This one feels different, in particular given the concessions made by speaker McCarthy to win over holdout votes for the House speakership. What’s your perspective on how this year’s fight over the debt ceiling could be different?
Well, Bill, I think you really nailed it in the intro, right? Few policy matters in Washington have such destructive economic capability as the weaponization of the debt ceiling. And this is really the first time this has happened since 2011. 2011 is a really useful case study and policy toolkit to unpack what could happen.
Keep in mind, too, right, it’s two issues here. It’s not just the X date and the potential to go over the X date, getting into technical default scenarios, it’s also the credit raters. So 2011, that fight did trigger the first credit downgrade, which saw extreme market volatility in August of 2011. I think the difference between what is going on right now and 2011, in 2011, the House Republicans had a very strong Speaker with John Boehner of Ohio.
They also had a 23-seat margin. Fast forward, we have Kevin McCarthy with an incredibly narrow four-seat margin that could even shrink by the time this starts to crest in the summer. During the 2011 debt ceiling saga, the debt was a little under $15 trillion, which was approximately 95% of debt-to-GDP ratio. The debt is now 31.4 trillion, right? It’s doubled in a little over 10 years. And that accounts for approximately 120% of a debt-to-GDP ratio. It’s the first time this has happened really in 12 years, but it does feel like not only is this a little bit different, unfortunately the setup is arguably worse than 2011.
Chris, if the debt limit were not raised, the amount of spending cuts or tax increases that would be required has been pegged at about one and a half trillion this year and 14 trillion over the next 10 years, according to Brookings. Where do you see the potential for spending cuts as part of a compromise?
Well, if we go back to 2011, that got about 2.2 trillion in deficit reduction, with a combination of statutory caps on annual spending along with sequestration, those fairly Draconian 2% cuts across the board. Where we are now, it’s a much smaller universe. On one hand, you still have the administration and a number of congressional Democrats saying that there should not be any spending cuts while the debt ceiling is being held hostage. Most congressional Democrats and the White House are willing to have a discussion on the debt and the deficit, but having that discussion while, in their estimation, House Republicans are using the debt ceiling as a hostage is just not something they want to entertain right now.
In terms of the nucleus of cuts, the big drivers of the deficit are the entitlements and defense spending. Social Security, Medicare and defense spending are all off the table in these discussions. So what we’re really talking about is probably a version of 2011 with statutory caps on discretionary spending. One area also to keep an eye on is there’s approximately $200 billion in unused COVID-19 funds. These were grants sent to state and local governments during the early stages of the pandemic. So spending cuts is being swapped out with spending rescissions. At best, we’re probably talking about, relative to 2011, 10% of what was discussed in 2011.
Chris, let’s get into some potential scenarios on how this might play out. What do you see as some of those potential scenarios and which one do you think is most likely?
Right. Well, so in the Ahead of the Curve piece, we flag six of the potential endgame scenarios. But in reality, our base case and, in our estimation, the most likely outcome here is what we call the build more land scenario. This is a play on the old DC Axiom. Whenever DC finds itself on the edge of a policy cliff, it generally builds more land, right? This is a version of a kick the can and the vehicle for this is likely with Senator Mitt Romney’s TRUST Act. Senator Manchin, another very powerful centrist has also weighed in on this. And the general idea with the TRUST Act is that a special committee would be formed bipartisan from House and Senate members to look at the main trust accounts, right?
Social Security, Medicare, Highway Trust Fund, et cetera and the idea would be some type of bipartisan agreement on deficit reduction. If that rescue committee came up with a bipartisan agreement, it would immediately set up votes on the House and the Senate. So it’s a way to get around some of those procedural and parliamentary roadblocks that could be formed either through a filibuster in the Senate or with the House Rules Committee. Having said all of that, this is basically kicking the can to a committee that probably wouldn’t have an enforcement mechanism, but you raise the debt ceiling or suspend the debt ceiling until sometime after the ’24 elections and we live to fight another day.
Chris, an intentional default has never happened, of course, but that doesn’t mean it can’t happen. What’s your perspective on the parties involved doing the unthinkable?
X date plus one brings into a lot of very frightening both market structure questions and sort of get into the plumbing of the global financial system with repos and using treasuries, et cetera. One of the unilateral options available in theory to both Biden and the Treasury Department would be what’s known as prioritization. We would argue that this is sort of, you’re arguing the nuances and semantics of defaults, so you’ve probably already lost the game here, but the argument with prioritization and is that essentially the Treasury Department can pay interest on treasuries first, so it’s not sort of a Russia-style default. From 1998, you’re still paying interest to bond holders, although by definition you are defaulting on obligations to troop pay or federal worker pay, et cetera, but they’re within the unilateral options available to the administration. Prioritization is one that gets a fair bit of oxygen.
Chris, what are you watching to gauge progress towards an agreement? What’s coming up that investors will want to pay attention to?
The two big fiscal events this year. The first one, no surprise, it’s what we’ve been chatting about, that’s the debt ceiling. The second big fiscal event of the year though is the FY ’24 budget process. So the earliest the X date could be is June 5th. The new budget cycle begins on October 1. Now, both of these dates and events are currently on parallel tracks, but come March and April, they’re likely to intersect around March 9th, President Biden will unveil his FY ’24 budget sometime around April 17th, House Republicans will unveil their budget and those are probably the next two big key dates to watch because that’s when you’re very likely to see House Republicans tie themselves in knots trying to pass a budget. You’ve got, to your point earlier from McCarthy to secure the speakership, he had to give numerous promises to the more hard line members among House Republicans on things like balanced budgets, et cetera.
So I think the inability for House Republicans to pass a budget is late April when the X date is right around the corner. As we’ve said for a couple months now, the vote for speaker is the easiest vote in the house for two years full stop. It took House Republicans 15 votes to elect a House speaker, that ungovernable House majority come April, May, June, maybe later into the summer when you’re tackling issues of global significance like the debt ceiling, think that’s when investors are likely to really start taking notice and prepare for a white knuckle spring and summer perhaps into the fall.
Chris, before we wrap up today’s podcast, I want to thank our listeners for tuning in and Chris, thank you so much for your insights. Be well and see you next month.
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