US budget deal: Was it worth the fight?

Dr. Harm Bandholz, CFA
Chief US Economist
UniCredit Research

Harm Bandholz is the Chief US Economist for the UniCredit Group in New York. Before coming to the United States, Harm worked as an economist at HypoVereinsbank and as a Research Assistant at the Ifo Institute, both in Munich, Gemany. He holds a PhD in economics from the University of Hamburg and is a CFA Chartholder. Harm is also a member of the American Council on Germany and The Economic Club of New York.

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The Congressional Budget Office has today released the estimated impact of the fiscal compromise, the “Budget Control Act of 2011”, on the deficit. The CBO report also contains additional information about the proposed legislation that is more detailed and in some cases differs slightly from the numbers that were leaked yesterday. The legislation would:

– Establish a procedure to increase the debt limit by USD 400bn initially and procedures that would allow the limit to be raised further in two additional steps, for a cumulative increase of between USD 2.1 trillion and USD 2.4 trillion.

– Establish caps on discretionary spending through 2021; these are estimated to save USD 756bn, which is the bulk of the USD 917bn spending cuts that are already been agreed on.

– Create a Congressional Joint Select Committee on Deficit Reduction to propose further deficit reduction, with a stated goal of achieving at least USD 1.5 trillion in budgetary savings over 10 years.

– Establish automatic procedures for reducing spending by as much as USD 1.2 trillion. If, by January 15, 2012, enactment of legislation originating with the joint select committee does not achieve the targeted deficit reduction, the bill would require reductions in both discretionary and direct spending to make up for any shortfall in that targeted savings. Those automatic reductions in spending would be spread evenly over the fiscal years 2013 through 2021; half would come from defense spending and half from nondefense spending, including both discretionary and direct spending.

First of all, it is very good news that the leaders of both parties in Congress and the White House have finally reached an agreement to raise the debt ceiling, avoid default, and to lower the deficit. That of course implies that both chambers of Congress will today approve the proposed legislation. But as the dust settles, one might ask whether the debt-ceiling fight was really worth it. In some sense, it may be was. First, despite entrenched positions, the parties were after all able to find a compromise. Second, the debate has highlighted how big the US debt problem really is, and that austerity measures are unavoidable.

Unfortunately, the current proposal does not yet reflect this new awareness. Instead, it once again kicks the can down the road! First, the so-called “immediate” spending cuts of USD 917bn do of course not begin this year. And they barely have an impact in 2012 or 2013 either. As the bulk of these cuts are achieved through spending caps, which allow discretionary outlays to grow slower than in CBO’s baseline scenario, in which appropriations are assumed to grow each year with inflation, most of the savings occur only at the end of the forecast horizon. According to the CBO, the proposal will cut the deficit for 2012 to 2014 by a cumulative USD 122bn, or USD 40bn per year – that is a mere quarter of a percentage point of GDP (see chart in pdf-file). In nominal terms, the proposed caps on appropriations of new discretionary budget authority continue to rise from USD 1,043bn in 2012 to 1,234bn in 2021.

That led Ron Paul, the outspoken Congressman from Texas, to make the following comment: “Instead, the “cuts” being discussed are illusory, and are not cuts from current amounts being spent, but cuts in projected spending increases. This is akin to a family “saving” $100,000 in expenses by deciding not to buy a Lamborghini, and instead getting a fully loaded Mercedes, when really their budget dictates that they need to stick with their perfectly serviceable Honda.” There is certainly some truth in this statement. First, the deficit cuts over the next decade are almost certainly not yet deep enough (but this is not only a function of outlays, but of revenues, too). Second, lawmakers have been very cagey about the baseline to which the spending “cuts” are measured. On the other hand, nominal outlays are not the best indicator to measure fiscal discipline. Instead, one should focus on real outlays or outlays as a share of GDP. And both of these measures are projected to fall under the current proposal – albeit possibly not enough. Second, the hot-button issues, entitlement reform and tax reform, have not even been touched. Instead, they are supposed to be debated by the Congressional Committee.

President Obama, too, stressed in his remarks yesterday: “Now, is this the deal I would have preferred? No. I believe that we could have made the tough choices required – on entitlement reform and tax reform – right now, rather than through a special congressional committee process.” The President highlighted that in this second part of the agreement, i.e. the committee, “everything will be on the table”. But the automatic spending cuts that kick-in if Congress would not approve the committee’s recommendations unequivocally show that the party leaders are all but convinced that an agreement on these topics can be reached. We share these concerns. And if Congress would indeed not agree on measures to cut the deficit by the end of the year, the automatic cuts do only refer to outlays. That means that the entire deal would not include higher revenues, which makes the outcome very unbalanced (one caveat is, however, the future of the so-called Bush tax cuts, which expire at the end of next year. If Congress cannot agree on the committee’s proposal, which is likely to deal with the expiring tax cuts, tax rates might go up at the end of the year).

Long story short: The prolonged and partly messy political debate about the debt ceiling did not improve the final product. The compromise proposal to reduce the deficit is in our view disappointing as it merely kicks the can down the road and represents the smallest common denominator between the political parties. Hot-button issues, such as entitlement reform and tax reform, were simply ignored so far. Such a deal could have been reached months ago, without putting the government on the brink of default! In addition, the overall legislation would reduce the budget deficits over the next decade by “only” USD 2 to 2¼ trillion USD. That is significantly less than the USD 4 trillion requested by Standard & Poor’s. Hence, if the rating agency is willing to walk the talk, it would have to downgrade the United States in the coming weeks, regardless of the budget deal. We do, however, think that S&P might wait until the end of the year to hear the proposals of the new committee and see, which steps Congress is willing to implement. In case, these measures are deemed insufficient – which is all but unlikely as already the savings target is too small –, a downgrade might follow. And while Treasury yields fell sharply in recent weeks despite the looming default risk, Mohamed El-Erian warned that “We simply do not know how the global system will operate without the triple A. We’ll see a lot of realignment that can be very costly. We’ll be in the land of the unpredictable.” Politicians, therefore, should better not take the gamble.

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Dr. Harm Bandholz, CFA
Chief US Economist
UniCredit Research

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