Hard-fought debt deal awaits Congress approval

If Congress approves the deal as expected, the US will be set on course for a decade of cuts and reforms

As with the European debt crisis, the US debt ceiling negotiations between the Democrats and the Republicans in the US Senate were an acute symptom of a more long-term malaise. The two sides, though fiercely engaged in their political battles, pulled back from the brink at almost the last moment.

The deal did not impress President Obama and it is unlikely to impress the credit rating agencies. The deal, which has to be approved in Congress today, sees the debt ceiling raised by $2.1trn, with budget cuts of $2.4trn or more over a decade.

The projected 2011 federal budget deficit will be $1.645 trillion, or 10.9% of GDP, according to the US Office of Management and Budget. Obama and the Democrats wanted to raise the debt ceiling, but the Republicans and others insisted on structural reforms, fearing yet more spending would cramp the dynamism of the US economy.

It is the wrangling over the issue that has created uncertainty in the minds of the markets, prompting Standard & Poor’s and Moody’s to warn about a possible credit rating review. This reflects the view of the US economy more widely.

Argyle Executive Forum, a professional services firm, surveyed 470 of its members on the US debt crisis: almost 95% said the country’s law makers had failed to meet their expectations. Their pessimism is also evident from the almost 60% who were ‘not confident’ a resolution would be met by the August 2 deadline. A further 9% said there was ‘no chance’ of the deadline being met.

The respondents may have been unduly pessimistic, but the US economy is not out of the woods yet. Some analysts believe that a credit downgrade will happen at some point in the next few months. S&P is looking for a $4trn medium-term fiscal consolidation plan, if it is to affirm the US’ AAA rating. Moody’s stated they would affirm the AAA rating if the debt ceiling was raised.

In a note, Neuberger Berman dismissed claims by the US Treasury that it will run out of cash on August 2: “given their cash on hand and tax receipts running approximately 10% ahead of 2010 levels, we think that August 2 is not the ‘drop-dead’ date that is being portrayed.”

However, the note says, “failed spending and tax policies and unfavourable demographic changes, combined with an adverse debt-growth mix, have created a situation that is unsustainable.”

A technical default remains on the cards, whereby the US government would delay payments of bond interest and principal. This has happened three times in US history, most recently in 1979, when some T-Bill payments were delayed. The biggest problem the US government faces is the divergence of revenues and outlays, a trend that started in the mid-1980s. Fiscal consolidation and increasing revenues are both politically difficult, and the solution is going to have to involve a long-term reform package.

A technical default is not the stuff of drama. In the event of a larger event, such as a longer delay in paying interest, questions would be raised about the government’s ability or willingness to pay its debts. Berman says “this would affect all asset classes and could fundamentally change the stability of the financial system. The probability of this outcome, in our view, is de minimis, and something that even the most fervent deficit hawks want to avoid.”

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