Revisiting the debt ceiling

• Once again we are heading for a budget battle in the US Congress. The current budget resolution runs out on 1 October and the Treasury Secretary stated this week that the debt ceiling is likely to become binding around mid-October.

• This leaves politicians with less than a month to come up with a solution. If a budget is not passed before 1 October, the US will have a government shutdown. The consequences of not raising the debt ceiling are even worse: a debt default.

• There is so far little sign of compromise between Republicans and Democrats but we believe that party leaders will try to avoid a situation similar to summer 2011. The challenge is to get the fractions within each party to support this line.

Another political circus coming up

Once again a battle over the US debt ceiling looms on the horizon. The US officially hit the debt ceiling of USD16.7trn on 19 May. Since then the Treasury department has taken extraordinary measures, primarily halting reinvestment of securities held in the G retirement fund for Federal employees, to keep the government funded. However, this Monday, Treasury Secretary Jack Lew sent a letter to Congress explaining that these extraordinary funds will likely run out by mid-October. This leaves politicians limited time to agree on raising the debt ceiling.

To complicate matters, the budget that currently funds the government has to be renewed or replaced by end-September. If a deal for FY 2014 is not agreed upon before this time, the US will face a so-called government shutdown. This means that all government nonessential services will be shut down and a substantial portion of government employees would be furloughed, causing a substantial drop in disposable incomes.

If Congress cannot agree on a budget resolution for FY 2014, one possibility would be to implement a continuing resolution, allowing the government to operate at or below the level it has operated at previously for a period of time. A number of Republican politicians have proposed a contingent resolution running for four to six weeks, which pushes the deadline for a budget deal to mid-November. So far, the proposal has not been sent to Congress.

History should help calm down fears

History might calm down fears of another political catastrophe. It seems that politicians have learned a lesson from the ugly process leading up to the debt ceiling increase in summer 2011. At least, the debt ceiling increase and budget negotiations this spring went far more smoothly than might have been hoped for. A deal which suspended the debt ceiling until 19 May was agreed upon in January shortly after the fiscal cliff deal was in place. The proposal to temporarily increase the debt ceiling was put forward by House Republicans, headed by speaker Boehner – an indication that the Republicans see it as a losing strategy to ignite another fight over the debt ceiling.

In addition, the contingent resolution that funded the government for most of FY 2013 ran out in March 2013, which raised fears of a government shutdown early this year. However, after an initial but short-lived discussion on the sequester part of the budget, a budget deal was done by Congress which funds the government for the remainder of this fiscal year – i.e. to end-September.

Political positions – same old story

Negotiations over the 2014 budget and debt ceiling are likely to intensify when the Congress returns from recess on 3 September following Labor Day. So far, Democrats and Republicans are taking their usual stance. Obama has stated on several occasions that he will ‘not negotiate over the debt ceiling’, implying that a budget deal on FY 2014 should automatically include an increase of the debt ceiling. A central part of the budget negotiations will likely concern possible changes to the sequester. Democrats are calling for a ‘balanced’ approach to reducing debt, meaning both spending reductions and tax increases. Republicans are focused on easing the cuts to defence spending implied by the sequester. More challenging is the demand from some conservative members of the Republican party who want to connect any vote to increase the debt ceiling with changes to Obamacare. If Republicans hang on to their demand to change the health care law, this raises the risk of a government shutdown at the end of September as such a proposal is unlikely to ever go through Congress with Democrats in control of the Senate.

Even if the final deal means that the sequester is allowed to run in unchanged form for the next fiscal year, fiscal headwinds to growth next year will fade significantly. The main source of fiscal tightening this year was the tax increases on 1 January and the growth impact from these wanes as we move closer to 2014. Using CBO’s estimate for the budget deficit in 2014, which assumes that the sequester will continue unchanged, our calculations show that the fiscal drag on growth will shrink from above two percentage points this year to less than a half next year.