The Looming Budget Crisis — Not Crying Wolf This Time
Author: Greg Valliere
July 9, 2019
IN ALL OUR YEARS OF COVERING WASHINGTON, there’s rarely been an issue as complicated as the deadly-serious budget fight that seems inevitable this fall — or earlier. There are huge issues between (and within) both parties, and an acute lack of time before key deadlines arrive. It’s a story the markets will have to watch, as we explain below.
THE CONVENTIONAL WISDOM until yesterday was that both parties and the White House could hammer out a deal this fall on raising the debt ceiling, setting new spending caps, and avoiding a government shutdown when the new fiscal year starts on Oct. 1. But that scenario shattered with the release yesterday of a new study that warned the debt ceiling could be breached in early September, while Congress is still on a six-week vacation.
THERE ARE SO MANY MOVING PARTS in this dysfunctional narrative that the easiest way to explain the crisis is to prioritize the threats to the markets:
Extremely serious for the markets: The U.S. debt ceiling was hit on March 1; since then, Treasury Secretary Mnuchin has juggled federal assets to keep the government running. He will run out of tricks this fall, perhaps as early as the first week of September, before tax revenues pick up later in the month. He and other experts thought the deadline could be extended until October, but very disappointing corporate tax revenues could lead to a crisis just after Labor day — and Congress doesn’t plan to return from its August recess until Sept. 9.
This is so serious that Congress may have to return earlier — or deal with the debt ceiling before their vacation starts later this month. Failure to raise the debt ceiling could literally cause the government to run out of money and — most ominously — cripple Washington’s ability to pay interest on the federal debt. To be clear — a debt default is highly unlikely, but chances are not zero. Anxiety in global and domestic markets will increase as the deadline approaches.
Why can’t Washington simply raise the debt ceiling? Nothing is simple in this politically radioactive town; and the debt ceiling battle probably will get tied to spending levels. First of all, conservative House Republicans are extremely reluctant to approve any debt ceiling hike — which makes it possible that the Trump Administration will need votes from Nancy Pelosi’s troops.She loathes President Trump and will seek a high price — dramatically higher spending for domestic programs.
The problem for Pelosi, who’s had a rocky month with her restive members, is that there’s no unified Republican stance on the debt ceiling. Just as Trump has warring factions on trade, he has warring factions on the budget. Hard-liner Mick Mulvaney wants a spending freeze in the upcoming fiscal year, which is totally unacceptable to Mitch McConnell and most Senate Republicans, who want big hikes in defense spending.
So how does the debt ceiling get resolved? Probably in a deal in early September; Congress probably will skip town and go on its August break before a deal is done. We don’t rule out a “kick the can” debt ceiling agreement lasting only a few months, but even that would have to unite warring factions within the GOP, which then would have to negotiate with Pelosi. This enormous uncertainty is likely to annoy the markets — and give the Federal Reserve another excuse to stay accommodative.
Very serious for the markets: We’re not in the camp that sees an imminent recession, but a radical cut in federal spending would remove stimulus from the economy just when it might need more. Failure to raise budget caps for defense and domestic spending would certainly be a headwind for the economy. Under a complicated budget deal earlier in this decade (too complicated to explain here), budget caps were imposed with a penalty — “sequestration” — which would automatically cut spending.
But these caps have been ignored recently, as Congress violated the caps with impunity. Now Mulvaney and other deficit hawks want to enforce the caps, which could result in about $125 billion in spending cuts in next year’s budget — a whopping $71 billion for defense and $55 billion for domestic spending. McConnell adamantly opposes this, as does most of Congress.
Trump will bluff, calling for a spending freeze in a one-year deal, but at the end of the day he’s likely to cave and agree to a two-year package; whether he’ll get his $750 billion for defense next year is unclear, however.
So there’s a threat that the fat years for defense could come to an end, and that fiscal restraint could come at exactly the worst time for the macro economy. The more likely scenario, however, is that Mnuchin, Larry Kudlow and other pragmatists will persuade Trump to cut a deal that increases spending across-the-board, which will anger House conservatives and result in such gridlock that a government shutdown once again could enter the picture.
Not real serious for the markets: A shutdown is very unlikely on Oct. 1. As usual, there will be “continuing resolutions,” eventually postponing a final compromise on appropriations bills until just before Christmas — a rich Washington tradition. Could there be a shutdown at some time during the coming winter? Yes, with both parties posturing for the next election, anything is possible. But it’s worth noting that the markets yawned during a shutdown earlier this year.
WE APOLOGIZE FOR THE LENGTH OF THIS PIECE, but the looming budget crisis is maddeningly complicated, with lots of political intrigue and potential risks to the markets. Our bottom line is to bet on McConnell, who can deal with Pelosi. He may get his way: more spending, a debt ceiling increase, and a two year deal. This is the best bet, but not a certain bet — and the road ahead looks exceedingly rocky.
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