Fiscal Cliff Update: a Short-Term Debt Limit Extension Shifts the Battlefield

Reports from the House Republican’s Williamsburg retreat suggest growing momentum in favor of a short-term debt limit extension.  This follows calls over the past few days from several prominent Republicans to raise the debt limit, and soon.  This is good news for markets but not an end to fiscal uncertainty, as the battle shifts to the dual cliffs of the sequester and the continuing resolution (CR) funding the government after March 27.  The odds of a government shutdown in the absence of a CR, at least for a few days, are high.

The sequester becomes effective on March 1, though the cuts are to be made from the CR that funds the government after March 27.  That in effect means that the sequester and CR cliffs are linked together.  A deal on the CR could in principle restore the $85 billion in cuts for FY13 in the sequester (actual spending in 2013 from the sequester is about half of this amount), and there are strong constituencies in both parties for doing that.  In a grand bargain, the sequester likely would be turned off.  However, if the recent pattern of small, last minute deals holds, it’s difficult to image agreement on an additional $85 billion in cuts that would be needed to “pay for” the unwinding of the sequester for FY13.  Relative to my earlier post, this suggests a ¼ of a percentage point in fiscal drag this year, for a total of 1 ½ percentage points.

Meanwhile, the debate over what Treasury would do if the debt limit is not extended goes on.  Treasury and the Federal Reserve have dismissed the idea of a platinum coin, and there is substantial opposition among legal scholars to the idea that the 14th Amendment to the U.S. Constitution provides the authority for the president to ignore the debt limit.  This would leave the administration with the choice of paying bills as they become due (which would lead quickly to default) and prioritizing payments.  Prioritization is logistically difficult and presents awful political choices, so it’s not surprising that the administration is downplaying it as a possibility even though a 1985 GAO analysis suggests it would be legal to do so.

Could Treasury issue IOUs for bills it cannot pay that would avoid default, yet not count against the debt limit?  The debt limit law does seek to constrain the administration’s ability to do this, in particular by defining debt broadly as “any obligation issued on a discount basis that is not redeemable before maturity at the option of the holder of the obligation.”  For any such debt, the amount of money received for the instrument, adjusted for discount at issuance, counts to the limit.  On its face, that would seem to rule out explicit use of IOUs. Proponents, however, note the precedent of California doing exactly this, issuing IOUs (or “Registered Warrants”) to pay certain obligations when the state ran out of money in 2009. Those warrants promised payoff on a certain date, if the cash was available, and paid interest.  Holders of these IOUs were able to monetize their claims through banks. Several market participants that I’ve talked to were of the view that the premium charged by the market for these instruments would be small in the current environment.

A one-week delay by the IRS in the start of the tax refund season may help near term cash flow, but the debt limit still is expected to become binding in late February or early March.

Addendum: Politico reports that House Republicans will vote next week on a plan to raise the nation’s debt ceiling for three months, and it will include a provision that would stop pay for members of Congress if the Senate doesn’t pass a budget.  Stay tuned.