10/2/13 – Shutdown in Washington, DC: The Hole Gets Deeper

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 2, 2013 10:59:58 AM

and tagged Politics and the Economy

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With the government shutdown entering its second day—and apparently no negotiations under way between the Republicans and Democrats—the prospect of an early compromise agreement doesn’t look good. A headline in today’s Wall Street Journal, “Capital Digs In for Long Haul,” pretty much says it all.

The markets yesterday seemed to shrug off the shutdown. Much of the commentary has been along the lines that the shutdown is no big deal, a compromise will certainly be reached, and this is actually a buying opportunity. That may end up being the case, but I think it makes sense to at least consider the other possibility: that the stalemate continues until the Treasury runs out of accounting tricks to avoid the fact that the government is now at the debt ceiling, which should be in the next couple of weeks.

The hardening of positions on both sides is one reason I think this possibility deserves a look. Both parties are negotiating from principle, rather than from what they perceive as self-interest. This makes it much easier to justify their positions as being for the greater good—and, therefore, much harder to allow a compromise. This attitude is particularly prevalent in the conservative wing of the Republican caucus, as the WSJ and others note, but it’s visible in both parties.

Moreover, both sides have backed themselves into corners with their bases, publicly and privately. As outside interest groups get engaged in the debate, positions harden even further.

The final problem is that the shutdown and the debt ceiling are being forced together into one debate, which raises the stakes, complicates the issues under discussion, and makes a deal potentially even more difficult.

With all of these moving parts, the extension of the shutdown to and past the point at which the government doesn’t have the cash to meet all of its obligations certainly seems possible—particularly since that point is only weeks away.

I use the phrase “doesn’t have the cash to meet all its obligations,” rather than “default,” because “default,” especially in the bond payment context, involves certain technical characteristics that the Treasury will move mountains to avoid. (I discussed the different levels of default in a previous post.) That said, we can make some estimates about when that would happen, and what the consequences would be.

The facts in this analysis are taken from a piece put out yesterday by Capital Economics, an economic consultancy we use here at Commonwealth. According to their reading of federal data releases:

  • At the end of last week, the Treasury had about $16B in cash on deposit at the Federal Reserve.
  • The cash balance can reasonably be expected to run down to $0 sometime in October.
  • At that point, the Treasury will only be able to spend what comes in the door.
  • Over the next two months, there are no major tax receipt days, so tax income should run, at best, $10B–$15B per day.
  • Big spending days will be social security at $12B on October 17 and 25, and $25B on November 1.
  • A $30B bond payment appears to be due on November 15, based on historical data.

It is legally and operationally unclear whether the Treasury can prioritize some payments over others. Even if it can, with all of the spending commitments in place, Capital Economics expects that the Treasury will probably be able to make the October social security payments but may not be able to swing the November social security and bond interest payments.

You can argue about the timing of the payments or the timing of receipts, and even the meaning of “default,” since there’s no doubt that any such default will be driven by politics rather than underlying economic problems. But the fact of the matter is that the clock is ticking, and any inability of the U.S. government to pay social security, much less contractual bond interest payments, will not be viewed positively by markets—to say nothing of the voters.

In 2011, the last time we came this close to the debt ceiling, markets got hit hard. The hope is that we’ve learned from the last experience, and that Congress and the White House can come to an agreement before matters really get critical. The problem is they don’t have that long to do so—and they’re not talking.

The probability remains that an agreement will be reached. If not, I have no doubt at all that contingency plans have been drawn up to deal with the worst of the potential consequences. Nonetheless, the range of possible bad outcomes continues to expand, and the hole we find ourselves in keeps getting deeper.

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