U.S. DEBT CRUNCH : A NATION TAKEN TO THE LIMIT / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( A MUST READ )

July 14, 2011 9:42 pm

US debt crunch: A nation taken to the limit

By Richard McGregor, James Politi and Stephanie Kirchgaessner

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Time nearly up: the National Debt Clock in midtown Manhattan this week. Unless Congress lifts the nearly $14,300bn ceiling by August 2, the US faces default. That would be seismic for a global economy already agitated at Europe’s debt woes

Near the end of his meeting with members of Congress on Wednesday, Barack Obama snapped at Eric Cantor, the House of Representatives majority leader, who has been pressing the Republicans’ hardline position against any revenue increases in talks over the national debt.

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“I’ve reached my limit,” the president said before abruptly getting up from his seat to leave the meeting, according to an account given by Mr Cantor’s office. “This may bring my presidency down but I will not yield on this.”

The president has earned his label “no-drama Obama” through a brutal campaign to win the presidency in 2008 and rolling crises in office since then. But his cool demeanour has been stretched to the limit in the nerve-racking budget negotiations.

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An increase in the country’s borrowing limit is vital to service debts and to keep the federal government running. If the talks fall apart, the US could default – a seismic event that would do more than damage the country’s sputtering recovery and unnerve a global economy already spooked by Europe’s debt woes. The failure of Democrats and Republicans to reach a deal would also be an unmistakable symbol of how an increasingly dysfunctional domestic political system can no longer successfully manage partisan differences.

For a world that still looks to the US for economic, political and diplomatic leadership, it would be a sobering moment. “Asking what the US economy might look like after a possible US Treasury default is akin to asking ‘what will you do after you commit suicide?’, ” says Steven Wieting, a Citigroup analyst.
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Influential operators in the financial markets have already drawn a line in the sand, with Moody’s, the rating agency, threatening to downgrade the US over the budget impasse. A default, warned Ben Bernanke, the Federal Reserve chairman, would be a “financial calamity”.
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The last time Congress failed to reach agreement on a financial rescue package – in 2008, when it initially voted down the troubled asset relief programme at the height of the banking crisis – the stock market dropped nearly 10 per cent.
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Mr Obama is now locked in daily talks in the White House with congressional leaders to secure a deal. Steny Hoyer, the second-highest ranking Democrat in the House, is among many in Washington who are warning of another financial crisis ahead if they fail.

Questions that need to be asked

1. What is the problem?

Barack Obama: The president has moved to the centre ground. His ability to stop benefit cheques if the Republicans refuse to compromise gives him great power

When Bill Clinton left the White House in 2001, he bequeathed George W. Bush a healthy surplus. But that evaporated over the next eight years – a result of two expensive wars, tax cuts for the wealthiest Americans and recession.

The sharp economic downturn after the 2008 financial crisis devastated tax revenues. A $700bn stimulus programme pushed through Congress by Barack Obama inflated the deficit to more than 10 per cent of economic output. The US now borrows about 40 cents for every dollar it spends.

But the cyclical deficit is in many ways a small part of the problem. The real trouble lies later in the decade, when the country’s ageing population will bring exploding costs in a host of popular government programmes.

Last month, the non-partisan Congressional Budget Office warned that in a likely scenario of policy choices, federal debt would be equivalent to more than 100 per cent of the annual size of the economy as soon as 2021 and would reach nearly 190 per cent by 2035.
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The implications are deadly, economists warn. The cost of servicing the debt could lead to a jump in interest rates, a crowding out of private investment and a fundamental diminution of US power.
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The dual nature of the deficit problem – a steep short-term shortfall combined with a cavernous long-term gap – makes a deal between the White House and the Democrats and Republicans more difficult. A general consensus exists that a plan to shrink the deficit by about $4,000bn during the next decade could be sufficient to stabilise the country’s debt levels and put them on a more solid fiscal footing. But a deal of that size may not be achievable.
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Instead, lawmakers may settle for a more limited agreement worth about $2,000bn, without tackling the long-term issues such as health spending. That would simply delay a solution until at least after the 2012 presidential and congressional elections.

Such a deal would leave both sides unsatisfied. In addition, with persistently high unemployment, some are pushing for new stimulus measures to be included in the package. But with political tensions expected to run even higher as elections approach, this may be the only opportunity for the passage of near-term government support for the economy.

2. What does Congress want?

Nancy Pelosi: As any deal requires Democrat votes to pass, the former House speaker is upholding her base's support for entitlement programmes

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Most negotiations are a process of give and take in which neither side gets every­thing it wants. The Republicans, however, have approached the debt talks very differently.

The original proposal from Barack Obama, the president, offered Republicans a deal that reflected the upper hand they hold in the deficit debate, based on the single point they have hammered all year, the paramount need to cut spending.
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Mr Obama’s plan for $4,000bn in deficit reduction over 10 years consisted of 70-80 per cent in cuts, with the remainder made up of new revenues. So tilted was it towards cuts, including an erosion of near-sacred federal retirement and pensioner health programmes, that his Democratic colleagues were up in arms.
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Nancy Pelosi, the former House of Representatives speaker and a standard-bearer for the liberal left, said there could be “no benefit cuts in Medicare or Social Security”.

Some on the right could see why Ms Pelosi was worried. David Brooks, a conservative columnist for the New York Times, called Mr Obama’s proposal the “deal of the century”.
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“If the Republican party were a normal party, it would take advantage of this amazing moment and seize the opportunity to put a long-term limit on the growth of government,” he wrote.

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But the Tea Party has changed the Republicans, who have refused to consider any revenue increases. Once, there might have been some flexibility in the conservative position, but the Tea Party has bought scores of new members to Congress with little loyalty to the Republican establishment.
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“They have come to town to transform Washington and then to leave,” says Norm Ornstein, of the American Enterprise Institute, a think-tank.
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The Democrats’ position also contains risks. All year, they have allowed the Republicans to take the lead on the deficit issue, refusing to issue their own budget proposals and betting that their opponents would over-reach.
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The Republicans’ plans for cuts have proved unpopular but the right has set the terms of the debate nonetheless. Not only have the Republicans left the Democrats behind in the policy debate – in recent weeks, Mr Obama himself has been threatening to do the same.
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3. What does the White House want?

John Boehner: House speaker and a traditional Republican. He agreed to talk to Mr Obama about a deal but backed off in the face of a revolt by Tea Party adherents

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For Barack Obama, the debt ceiling negotiations represent a precious political opportunity – a chance for the president to shed himself of the damaging perception that he is a “big government” liberal.

As it did for Bill Clinton in 1995, forging a grand ­bargain with his political rivals – which cut programmes such as Medicare and Medic­aid, while also agreeing to sweeping tax reform – would seal Mr Obama’s reputation as a centrist who was willing to defy his own party to fix the deficit.
In a press conference this week, Mr Obama hinted at an even more ambitious agenda, for a deal big enough to clear the fiscal decks for the second term that he wants, while allowing him to focus on other issues.
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“If you’re a progressive that cares about investments in student loan programmes and medical research and infrastructure, we’re not going to be able to make progress on those areas if we haven’t gotten our fiscal house in order,” Mr Obama said.

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But Jennifer Duffy at the Cook Political Report, a Washington newsletter, says it would be imprudent for Mr Obama to believe he can emulate Mr Clinton’s 1990s political prowess. Not only are the stakes higher in the debt ceiling negotiations than they ever were for Mr Clinton when he struck a deal to balance the nation’s budget; the political environment was also far less polarised than it is today.

The cuts and other reforms to entitlements under debate, including a possible increase in the minimum age of eligibility for Medicare recipients from 65 to 67, also run the risk of alienating many of Mr Obama’s supporters.
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“Looking like a centrist is one thing, but he also has to be careful about his left flank. He is walking a very fine line here, so it really depends on what the deal looks like,” says Ms Duffy. “At the end of the day, they want to avoid default and they want a deal in which they can look like they won more than they lost.”

Still, Mr Obama has to win over more than the Democrats to achieve a deal. Republicans say the grand bargain between Mr Obama and John Boehner, Republican speaker of the House of Representatives, fell apart not only because of disagreements over raising taxes but because Mr Boehner did not trust the Democrats to carry out entitlement reform.

4. What if the talks fail?

Michele Bachmann: Tea Party standard-bearer who says she will oppose lifting the debt ceiling no matter what. Rising in Republican polls for 2012

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For months, Tim Geithner, Treasury secretary, has been warning Congress about the dangers of failing to raise America’s borrowing limit.
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But this week President Barack Obama himself stepped in to spell out the implications of a default. On August 3, the day after the final deadline, the government was due to send out about 70m cheques, said the president. “This is not just a matter of Social Security cheques. These are veterans’ cheques, these are folks on disability and their cheques.”
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Without a deal, meaning “the coffers weren’t full”, he said he could not guarantee that the cheques would be posted.
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A default would be a logistical, economic and political nightmare. The US government would in effect have to engage in a massive triage effort, deciding which payments it was willing to make and which it chose to halt.
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International bond investors such as China, as well as government contractors and recipients of welfare, pensions and other benefits would all have to be placed in line because of what the Bipartisan Policy Center, a Washington think-tank, estimates would amount to an immediate and automatic 45 per cent cut in government spending.
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This dramatic fiscal retrenchment, coupled with increased borrowing costs, a likely drop in consumer confidence and the loss of the vaunted triple A credit rating, could plunge the US into a fresh recession. That would have severe repercussions for the rest of the world.
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Such is the level of political distrust that many Republicans – including Michele Bachmann, the high-flying potential candidate for the White House in 2012 – say the administration is just engaged in scare tactics. Along with other rightwing Tea Party loyalists, they contend that the August 2 deadline is a myth, adding that the government can pay the interest on its loans without defaulting.
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Inside the White House, the talks are not going well. After Wednesday’s session, Mr Obama abruptly left the room following a heated discussion.
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According to one Democrat present, the president ended the meeting by observing that the nature of the talks confirmed what many people said about Washington.
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“Enough is enough,” he is said to have told them. “I will see you all tomorrow.”

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Shaping the debate

Orrin Hatch, a longtime Republican senator, is facing a tough election challenge in his home state of Utah next year, writes Stephanie Kirchgaessner.
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His chief opponent is not a Democrat, but a campaign by an ultra-conservative anti-tax advocacy group called the Club for Growth, which this week started running advertisements urging Mr Hatch to vote “no” on an increase in the debt ceiling.
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The Club for Growth is just one of a handful of influential organisations that are shaping the debate in Washington and putting pressure on lawmakers to ignore dire warnings from economists about the impact of a failure to pass the debt ceiling.
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Grover Norquist, president of another anti-tax group called Americans for Tax Reform, is leading the charge against any increase in revenue as part of a broader debt ceiling deal. Mr Norquist even views closing special corporate subsidies, like those that have helped the ethanol industry, as a tax increase. Many in Washington, including Alan Simpson, the deficit hawk and former Republican senator, see Mr Norquist as one of the biggest impediments to a debt ceiling deal because of the influence he wields among conservatives.
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Regarding a recent vote to end an ethanol subsidy, Mr Simpson told the AP: “Grover Norquist and the anti-taxers called that a tax increase. I’ll tell you, if that’s a tax increase, I’m Mussolini.”
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The deficit reduction panel that Mr Simpson co-chaired argued in favour of cutting 180 tax breaks that cost $1,100bn.
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Pressure groups such as Club for Growth are facing some opposition from lobbying organisations like the US Chamber of Commerce and other big business groups that are trying to convince members of Congress that a default would spell disaster for the American economy.
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A century of ceilings
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The first version of the US debt ceiling was created in the Second Liberty Bond Act of 1917, which helped finance America’s entry into the first world war. Before then, the Treasury had to obtain congressional approval every time it wanted to borrow money.

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The 1917 ceiling was set at $11.5bn, a far cry from the $14,300bn level where it stands today. But it imposed differing limits for different categories of borrowing. The current aggregate debt limit was set up in 1939 and has been lifted nearly 100 times since then, with varying degrees of turmoil.

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Squabbling in 1979 led to a small technical default. The limit was raised only at the last minute and back-office trouble at the Treasury meant the US could not keep its payments on schedule for a sliver of short-dated bills.

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The incident was quickly resolved but interest rates ticked up as a result.

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Copyright The Financial Times Limited 2011