Fiscal Fiasco—This Time Is Different?

It now looks like the government will shut down this evening.   The Senate is likely to make one more effort to pass a clean continuing resolution (CR), but at this stage the Republican House seems unwilling to let go of its animus for Obamacare.  Perhaps they will settle for something symbolic–one idea is for Congress to forgo their insurance and go onto an exchange as part of the CR—but there is no evidence that discussions along these lines are taking place.

Most analysts expect a short shutdown, but I think that underestimates the odds that our politicians have dug a hole from which it could take time–more than a week–to dig out.

In a shutdown, the BLS and  Commerce Department will stop issuing data, so this Friday’s jobs report is off (but jobless claims will be released and the Federal Reserve will stay open for business).

Of course, this is a prelude to the debate on the debt limit later this month.  The odds also are at least 60-40 that we will go past October 17, the date the administration has set as the debt limit deadline, without a deal to raise the debt limit, and it now seems likely that the U.S. government will have to delay some payments (though not interest payments on debt) or issue debt above the debt limit before a deal is reached.

My prediction: a shutdown of around one week, a near-death experience on the debt limit with a short-term extension coming only around end October, and resolution in the form of a longer-term debt limit extension and full FY14 funding around the end of the year when the threat of sequestration forces the parties to talk to each other.  Spending next year will be at or very near the level given by the sequestration, ensuring a further substantial reduction in the deficit.

This is so disappointing:  the decision to raise the debt ceiling has always been political, but there seems to be a greater willingness these days to try and use it for political ends without regard for the economic costs.

Markets have begun to react, with the stock market declining slightly and the cost of insuring U.S. government debt increasing, but “market discipline” on our political leaders is likely to be too little, too late.  There is good reason for that:

1. A short government shutdown will have a very limited effect on the economy.
2. In virtually all scenarios, spending next year will be at or slightly above the level given by the sequester.   Thus, from a macroeconomic perspective, there is little uncertainty around fiscal policy absent a default on our debt.
3. After several years where politicians took us to the cliff, then stepped back, markets understandably remain sanguine that a deal will be reached on the debt limit.  There is a feeling that we’ve been through this before, and that politicians will eventually get a deal done to kick the can.  The good news is that, so far, markets have remained reasonably calm.  The bad news is there isn’t market pressure on politicians to do a deal. Also, if we are wrong, markets will have to correct sharply.

While markets are focused on whether or not the government pays on its debt, and sees default through that prism, any failure to pay on its obligations would be deeply unsettling. How long would it be politically or economically viable to pay the debt and not make other critical payments? Not long, I think.

So in the end I expect our politicians will again disappoint us, but will find a way to kick the can at the last minute.  Call me an optimist.