What if a Debt Ceiling Deal isn't Struck by August 2?

I am frequently asked the "what if" question about the looming August 2nd deadline on the debt ceiling/potential US default. To answer the question let me provide some context that I think highlights why we believe a deal is likely and becomes self-reinforcing as the deadline gets closer.

Because Federal government revenue is not collected evenly throughout the year, spending in most months vastly exceeds revenue. If there was no debt ceiling increase deal reached and implemented by August 2 funds would fall short of the $307 billion in planned spending for the remainder of the month by $134 billion, or 44%.

Think about that for a sec. This would not be business as usual for anyone.

The prospect of a 44% reduction in spending starting August 3rd on everything including: social security, military pay, food assistance, interest on the national debt, Medicare and Medicaid, educational aid, housing programs, unemployment benefits, federal salaries, etc, would have career-ending backlash for legislators.

Under a scenario where the stock market falls 20% or more, draconian spending curbs of 44% kick in, and the economy spasms, voter outrage with all parties would cause members of congress to quickly reconsider voting for a compromise deal on the debt ceiling.

Both sides can declare victory with a $1-2 trillion dollar package of spending cuts and debt ceiling increases that don't raise tax rates or involve material entitlement program cuts and that kicks the tough decisions on these issues down the road until after the 2012 elections.

Republicans can deliver on campaign promises to reduce spending and hold firm on tax increases. And a minor tweak to entitlements, such as re-indexing Social Security benefits to inflation rather than wage growth, shows they are serious about eventually dealing with the issues on longer-term fiscal sustainability.

A deal that involved raising revenue through closing some tax loopholes used by corporations or wealthy Americans would offer democrats a chance to declare victory, as well. A deal of at least a trillion would also demonstrate some fiscal restraint popular with voters ahead of a tough Senate race next year.

In the Weekly Market Commentary for July 5th entitled Will The Markets Hit The Ceiling? I provided a decision tree, probabilities and outcomes for the debt ceiling debate that provides added insight into this issue.

Jeff Kleintop, CFA, Executive Vice President, LPL Financial
July 14, 2011
 

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