9/23/13 The Good, the Bad, and the Ugly

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 23, 2013 10:04:24 AM

and tagged Debt Crisis, Politics and the Economy

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The past week has been interesting, with lots of developments. Rather than trying to cover just one, I thought we should look at several of the most important.

The Good: German elections

Angela Merkel, the current German chancellor, had a big win over the weekend. Her party did much better than expected; it may actually win an absolute majority for the first time since 1957. Germany has been the keystone of the post-crisis European financial system, so the election is critical to the euro and the eurozone. By retaining and even strengthening her position, Merkel will continue to be able to support the euro in a way that also works within the constraints of German politics.

She does not have an absolutely free hand—her existing coalition partner collapsed and will not be in the next government—but most of the changes will actually further her ability to support the euro. The most probable government will include a grand coalition with the Social Democrats. They are even more supportive of the euro than Merkel’s party, and the coalition will be able to provide a unified German support base across the political spectrum for any decisions made.

This is important because, with the election, the eurozone has dodged a bullet, although it is still stuck in a swamp. Many European decisions were postponed until after the German election and will now be coming due. These include additional support for Greece, with new bailout talks starting today; what to do about Portugal; European bank regulation; and others. All are contentious, all will require sacrifice from both Germany and other countries, and all will require action in the next couple of months. The good here is that Merkel’s dominance, combined with a grand coalition with the Social Democrats, will provide the best possible political basis for German political support of those decisions.

The Bad: Sequestration and the federal budget

With the current federal budget set to expire at the end of the month—that is, eight days from now—and with the government scheduled to shut down if a new budget is not passed, the federal budget circus is underway again.

The current state of play is that the House of Representatives has passed a temporary budget, one that would keep the government open until December 15, and sent it to the Senate—but the budget includes a complete defunding of Obamacare. This is dead on arrival in the Democrat-controlled Senate—which the House was well aware of—so the Senate will have to pass a separate bill that takes out the Obamacare defunding and send it back to the House for debate.

We then have two possible outcomes. First, the House passes an extension without defunding Obamacare, in which case we have perhaps two weeks of peace before the next political/financial crisis hits. Or, the Republicans who control the House decline to pass a budget that includes Obamacare funding, in which case the government shuts down.

Given the pending debt ceiling debate (see the next section), it seems likely that both the Democrats and the Republicans will defer any spending discussions and opt to continue the federal budget at current levels, including the sequester spending cuts. Additional economic damage is likely to be limited, if in fact a budget is passed and the government does not shut down. If it does shut down, the short-term economic damage could be substantial.

Here’s what I suspect will happen with the budget: With Congress and the White House setting up for a big-time face-off over the debt ceiling, they will decide to compromise and continue current spending levels on the theory that, since we are going to start digging a new hole, let’s not make this one any deeper. We can therefore expect lots of theatre, with the potential for real damage if the government shuts down. Of course, since it is not politically advantageous to anyone to have the government shut down in the run-up to the debt ceiling debate, we can expect a last-minute compromise.

The Ugly: The debt ceiling

This is the big one, and it is what everything else will be postponed for. In 2011, the last time we went through a debate over whether to raise the debt ceiling, we had gone through months of press coverage on the worsening financial situation by the time we got to this point. This time, the Treasury hit the limit last May—and everyone ignored it. As a result, we are now well into Defcon 1, and we’re headed for Defcon 2 in mid-October (per the terms I developed previously).

What is interesting to me is that even in 2012, people were more relaxed about the situation than they were in 2011, and this year, people have essentially ignored the debt limit until very recently. To the extent dysfunction has been normalized, we have a very real example that investors and citizens may not be any smarter than frogs, as the increasing temperature could boil us in pretty short order.

The expectation, again, is that a last-minute deal will be cut, and that, in any event, the contingency plans developed from 2011 will protect us. Expect to see them (and accompanying press stories) recycled. I certainly plan to do the same on my blog, as I did above.

The problem is that, each time, we get closer to the edge, raising the chance that miscalculation will push us over. Both sides are under more political heat this time—Obama for Syria, and the Republicans from the Tea Party, which has already forced Boehner to pass a budget that defunds Obamacare, even though he knows it will be dead in the Senate. With the politics getting even more uncompromising, there is a real chance we will hit the wall this time.

Should it actually happen, I expect the actual effects to be less than feared, as the government will adjust to minimize the damage, just as they did with the sequester. Still, just as with the sequester, the damage will be real, and since the effects will not be limited to spending, the damage may well end up being uncontrollable. This really is a big deal, with potentially—but not definitively—catastrophic consequences. The fact that we do not really know what might happen is part of what makes it scary.

The metaphor I am being forced to use this time is the Titanic, except we can actually see the iceberg coming straight at us. It might be a big one; it might be a fog bank. If it is real, it might not sink us. In any event, it certainly is something we should be keeping an eye on.

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