A Last Minute Deal Averts Default – For Awhile

From Andy Friedman

With the deadline for the United States to avoid defaulting on its debt fast approaching, Congress reached another late night compromise to reopen the government and raise the nation’s debt limit. The deal also called for yet another bipartisan committee to try to set a budget for future government spending. Before discussing what that committee is likely to do, let’s compare the predictions I’ve been making since early this year against the reality of what ultimately occurred.

Prediction: We will not default on the national debt. But the final legislation is likely to provide only a short term solution.

The midnight compromise permits the government to continue to borrow until February 7, 2014. The compromise also reopened the government and funded its operations through January 15, 2014. Other elements of the compromise:

  • Appointed a bipartisan Congressional budget conference committee to negotiate 2014 government spending.
  • Provided back pay to furloughed federal workers.
  • Required additional assurance that people who receive subsidies to purchase insurance under Obamacare in fact are entitled to receive them.

Prediction: Congress acts only in the face of a “forcing event”, that is, an event that makes inaction intolerable.

As it did with legislation to avoid the fiscal cliff that would have sent the country back into recession, Congress reached a compromise to avert default at literally the eleventh hour. Acute polarization prevents Congress from fashioning meaningful legislation unless and until it must do so to avoid serious consequences to the country. Even more worrisome than this trend is the concern that the severity of the necessary “forcing event” is escalating. For the past seventeen years, the risk of shutting down the government was enough to get Congress to respond. Now apparently the consequences of a shutdown are not sufficiently dire to force Congressional action.

Prediction: As we approach the twin deadlines of funding the government and raising the debt ceiling, the markets could get nervous and we could see a downturn. Because Congress will not allow the nation to default, that downturn should be temporary, with the markets rebounding once an agreement is in sight. Thus, investors should view the downturn as a buying opportunity.

Between September 18, when the market first took notice of the brewing conflict over funding the government, and October 8, when the Republican House leadership acknowledged that it would not permit the nation to default, the Dow lost 5.7% and the S&P index lost 4.1%. From October 8 through October 17, when Congress passed the compromise legislation, the Dow gained 4.0% and the S&P gained 4.7% to reach an all-time high. Investors who purchased equities on the downturn were rewarded.

Investors who missed this market inflection may find comfort in the fact that plenty more opportunities for Washington dysfunction are upcoming. I continue to believe that Congress will not allow the nation to default on its debt, and that any market downturn in anticipation of a debt ceiling deadline can provide a buying opportunity.

What happens next?

As noted above, the debt ceiling compromise calls for a bipartisan, bicameral “conference committee” to hammer out a budget for the government in 2014. The primary goal of the conference committee is to replace the next round of “sequestration” spending cuts that otherwise will take effect on January 15, 2014. These spending cuts, which were implemented as part of the compromise that raised the debt ceiling in August 2011, proportionally reduce spending for defense and other government functions. The cuts do not affect entitlement payments, such as Social Security, Medicare, and Medicaid benefits.

The sequestration cuts are not popular with either party. Most Democrats dislike the cuts to social programs, while many Republicans (and some Democrats) are wary of the cuts to defense. The Republicans will seek to replace the defense cuts with deeper cuts to social programs and cuts to entitlements. At the top of their list are changes to slow the rate of growth of Social Security cost-of-living increases through the use of “chained CPI”, and requiring affluent recipients to pay more for Medicare coverage.

Democrats will resist entitlement changes and will seek to offset the sequestration cuts at least in part with new taxes. Toward that end, the President has proposed a number of tax changes, including taxing municipal bond interest, limiting the amount individuals may accumulate in tax-preferred retirement accounts, and reversing recent expansions of the estate and gift tax exemptions. I can say with virtually certainty that none of these proposals will get through the conference committee.

More viable perhaps are some of the President’s proposals to close “loopholes,” including (1) eliminating the ability of someone who inherits an IRA or 401(k) to “stretch” the payments over his or her lifetime; and (2) curtailing the availability of sophisticated wealth transfer techniques such as grantor retained annuity trusts (“GRATs”), intentionally defective grantor trusts, and dynasty trusts.

If the conference committee manages to reach a compromise – no small feat, as evidenced by the failure of the “supercommittee” formed in the wake of the August 2011 compromise — the deal will be a small one. A possible result might alter the inflation index to slow the growth of Social Security benefits to appease the Republicans, and close some tax loopholes to appease Democrats.

If the budget committee fails to reach agreement, then Congress will have to make a choice come January 15. It could fund the government for the remainder of 2014 at the lower spending levels reflected in the sequester, or it could fail to pass a funding bill altogether in which case the government will again shut down. The bigger issue will come after February 7, when Congress will need to raise the debt ceiling to avoid default. In Washington, past really is prologue. Stay tuned.

 

Andrew H. Friedman is the Principal of The Washington Update LLC and a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance, and retirement products. He may be reached at www.TheWashingtonUpdate.com.