QVMS - The Federal Budget: Part II - Is This Time Any Different?

Summary

• Past episodes of debt ceiling histrionics have resulted in temporary government shutdowns.
• With both sides seemingly dug in, a repeat of the 2011 episode cannot be ruled out.
• In 2010, republicans controlled the House and demanded that President Obama negotiate over deficit reduction in exchange for approving an increase in the debt ceiling.
• Prior to the 2011 deal, the political atmosphere was so poisoned that Moody’s downgraded U.S. Treasury debt and the equity market suffered through a quick 20% decline.
• Because so much more of the treasury debt is held by foreign entities, prioritizing debt service does not seem to be politically possible.

Republicans have regained a majority in the House of Representatives, and they are introducing reforms to the oversight and fiscal processes. Our focus is on the fiscal process. The goal of the new majority is to presumably gain control over the size and composition of federal government spending. To be sure, federal spending exploded in the past two years because of the pandemic emergency and post pandemic actions to expand the social safety net and to stimulate economic activity.

But federal spending has been out of control for long before this period despite protestations from both parties to deal with it. In our recent The Federal Budget: Part 1 - Feeding At The Trough , we recounted the proclivity of both parties to ignore existing law and boost spending to achieve political goals. The Gramm-Rudman-Hollings ((GRH)) balanced budget law had a decent shelf life until a budget surplus in the late 1990s was upended by the war on terror and Congressional largess. The 2011 Budget Control Act ((BCA)) was suspended or amended when convenient such that actual spending exceeded spending caps by roughly $2 trillion through 2019 and by a lot more once COVID hit.

Considering this, one should be skeptical of any new efforts to restore order to the fiscal process. Indeed, it may be hubris, but the new majority is advocating a reinstatement of the spending restraint programs that both parties violated in the past, but this time on steroids. As a prelude to the ten year budget outlook soon to be published by the Biden administration and critiqued by the Congressional Budget Office (CBO), this report presents a brief summary of the measures the republican majority will seek to check and balance the executive branch.

One is to replace omnibus spending bills with individual spending bills being subject to committee hearings and floor debate. Amid floor debate any member would be permitted to offer amendments. Voting would occur no sooner than 72 hours after completion of a bill in order to give all members time to study the contents. These measures would probably receive bipartisan support, but it could open the door to forcing votes on items that might be popular but also expensive.

A second reform relates to a balanced budget amendment. The intent is to force a ten-year path to achieve budget balance. This has been tried before. In 1995 a balanced budget amendment passed the House and came within one vote of passing the Senate. An amendment was also offered in 2011 but was abandoned in favor of spending caps in exchange for raising the federal debt ceiling. It is very doubtful that a balanced budget proposal could gain momentum currently given the amount of social spending reduction that would be required to achieve budget balance.

But a similar set of pressures are building as a debt ceiling increase comes front and center this summer. In 2010 republicans controlled the House and demanded that President Obama negotiate over deficit reduction in exchange for approving an increase in the debt ceiling. The negotiation resulted in the BCA, but prior to a deal the political atmosphere was so poisoned that Moody's downgraded U.S. Treasury debt and the equity market suffered through a quick 20% decline. These events may have been what ultimately brought a deal to fruition.

It is often said that history is doomed to repeat itself. House republicans are now stating that they intend to force caps on federal discretionary spending by threatening to use their majority to prevent an increase in the debt ceiling. One of the demands by fringe conservatives is to cap fiscal 2024 discretionary spending at the 2022 level. In a budget appendix attached to last year's Biden budget outlook , federal discretionary spending was projected at $1844 billion in fiscal 2024 versus 1644 billion in fiscal 2022. Using current law CBO pegged the 2024 estimate at 1803 billion . But with inflation having accelerated in the meantime, the level would be even higher than 1844 billion. Moreover, an increasing portion of the federal budget is considered nondiscretionary. So, any plan to cap fiscal '24 spending at the '22 level would imply such draconian reductions in real spending that republicans would probably have a very difficult time agreeing among themselves.

As in 2011 both the Senate majority and the White House are currently voicing opposition to any plan to implement spending reductions in exchange for a rise in the debt ceiling. In 2011 there was an outcry that failure to raise the debt ceiling would threaten a debt default. So, at that time a Senate committee cleared a bill that would have prioritized debt service payments over other obligations. At the time Treasury Secretary Geithner said that prioritizing debt service would require cutting roughly 40% of all government payments . This could only be achieved, he said, by selectively defaulting on obligations previously approved by Congress. Nevertheless, the bill went nowhere.

In 2011 the federal debt was only 65.5% of GDP whereas the debt to GDP ratio currently exceeds 100%. Assuming very low interest rates, debt service is currently being projected to soon approach $500 billion annually. And with interest rates having risen, the level will soon be even higher. Complicating the issue, because so much more of the debt is held by foreign entities, prioritizing debt service does not seem to be possible. So, let the games begin.

Past episodes of debt ceiling histrionics have resulted in temporary government shutdowns. Republicans have typically gotten the blame and democrats are undoubtedly aware of this. As gamesmanship intensifies, the Treasury can take extraordinary action to meet its obligations by delaying payments to federal agencies, possibly monetizing gold reserves, etc. These are gimmicks rather than alternatives and republicans and the electorate know this.

So, with both sides seemingly dug in, a repeat of the 2011 episode cannot be ruled out. The shame of it is, though, that even in the event of a deal to limit spending and increase the debt ceiling, history tells us that these agreements are written in sand and easily blown away. The road to budget hell is filled with good intentions. But each time some externality occurs to snatch victory from the hands of defeat. For the sake of our kids and grandkids, let's hope this time is different.

Please note that this article was written by Dr. Vincent J. Malanga and Dr. Lance Brofman with sponsorship by BEACH INVESTMENT COUNSEL, INC. and is used with the permission of both.

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