Tuesday, October 1, 2013

Bridgewater Daily Observations: Risks associated with the budget and debt ceiling debates

John Broussard
State of Louisiana
Department of the Treasury

-----Original Message-----
From: Bridgewater Daily
Sent: Tuesday, October 01, 2013 8:53 AM
Subject: Bridgewater Daily Observations - "In our Observations of September 23rd, we laid out our thoughts on the risks associated with the budget and debt ceiling debates..."

In our Observations of September 23rd (which we have attached), we laid out our thoughts on the risks associated with the budget and debt ceiling debates. These risks are unfortunately playing out. Congress missed its September 30th deadline to pass the continuing resolution to fund federal discretionary spending. So the US now faces a partial government shutdown and the debt ceiling debate has not even begun. As we described, we think the markets were underpricing the risks. As we wrote: Most people have gotten used to Republicans and Democrats fighting each other with increasingly ominous threats that could undermine the wellbeing of the country and, at the same time most people have gotten used to them stepping back from the brink at the last possible moment, most people (hence the markets) assume that policy makers will come up with an agreement at the last possible moment. However, because the repeated false charges at each other by both parties have conveyed impressions of their weakness, both sides feel a greater need to stick to the lines they have drawn in the sand. Since irreconcilable differences are hardening, there is an increased likelihood that Congress and the President will not be able to make the necessary agreements before time runs out. Ironically, this is happening at the same time as the government budget deficit is shrinking toward a sustainable level (i.e., a level that the government's debt/GDP will stabilize) so that the cure might be worse than the disease.

What we're seeing is:
* Congress has not met the midnight deadline for passing a continuing resolution, resulting in the government reducing non-essential discretionary spending, which is about 15-20% of the federal budget, equivalent to about 3-4% of GDP annually.
* What's transpired so far looks to us more like political posturing - framing the vote and deflecting responsibility - than actual substantive negotiations.
* To the extent there is no substantive resolution, these negotiations run the risk of getting comingled with the debt ceiling debate, which is another complication.
* So there's a risk that the shutdown will run more than a day or two. Once Congress goes over the abyss, the incentives to make a quick deal recede until the next hard deadline.
* The next big deadline is tied to the debt ceiling. By October 17, the Treasury estimates that extraordinary measures will be exhausted and the debt ceiling will be reached.
* These risks are starting to flow into financial markets.

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