US Political Outlook: Smooth sailing for 2014?

“While open questions remain about how the debt ceiling will be raised, it is safe to presume that it simply will.”

The US government shutdown in October brought the world perilously close to another financial crisis. With another round of US budget negotiations looming in early 2014, what are the possible implications for investors? Mona Sutphen analyzes the deadlock and presents her outlook for the coming year.

If you are like most observers of the US political process, the near-constant brinksmanship and tendency to lurch from crisis to crisis is perplexing at best – and dangerously dysfunctional at worst. The government shutdown and potential debt default this past October may have been the breaking point.

Although a new deadline for lifting the debt ceiling looms in early 2014, further stand-offs are less likely for three reasons:

Reason One: Profound public disapproval

The shutdown and near-default were deeply damaging to everyone in Washington, especially to the Republicans. The public was firmly against the idea of shutting down the government – and potentially defaulting on debt. Polls consistently showed two-thirds of the electorate disapproved of Republican efforts – and over 60% had an unfavorable view of the party, an all-time high in many polls [refer to Chart 1].

As a result, majority of Republicans – many facing re-election in the Fall – are less likely to replay the debacle just months before facing voters. Even if their more conservative colleagues try to push for such a strategy, many are unlikely to go along a second time. In fact, the overwhelming desire to avoid another shutdown crisis was a major driver of the December deal to fund the government through FY2015.

Reason Two: Risk of voluntary default

Despite all the posturing, neither party is willing to breach the debt ceiling (the total amount of money that the US government is authorized to borrow to meet its existing obligations). Although it merely allows the government to finance payment of past spending commitments, the sums involved (now over $17 trillion) make it a politically sensitive vote.

Since August 2011, there have been multiple attempts to tie a raise in the debt ceiling to fiscal/budget adjustments. However on each occasion, the debt ceiling has been increased even when an agreement on fiscal/budgetary reforms could not be reached – because neither party wants to be blamed for a voluntary breach or default. So while open questions remain about how the debt ceiling will be raised, it is safe to presume that it simply will.

Reason Three: Political stalemate

The current political environment is not conducive to the kind of ‘grand bargain’ that would include entitlement reform and tax-code simplification. Politically, the red lines set by both parties on tax revenue and entitlements are in direct contravention to each other – and both sides are locked into their positions.

Further, recent CBO projections show the deficit falling to 3% of GDP. While the decline is temporary and remains above target levels, the trend-line is headed in the right direction – reducing the immediate urgency to act [refer to Chart 2]. Recognition of the political dynamics propelled budget negotiators to shift from a mega-deal mindset to a ‘think-small’ strategy – ultimately leading to legislative success.

The outlook in 2014

Although there will be no ‘grand bargain’ in 2014, merely avoiding a major crisis should be seen as a victory, given recent dynamics and the importance of removing headwinds to growth. While the December government funding agreement was small in size, it is important for two reasons: (1) it provides a level of funding certainty through the next election cycle; and (2) the law replaced the arbitrary ‘across the board’ nature of the sequester cuts for more targeted – and sustainable – cuts. In doing so, Washington may have given the economy what it needs most right now: certainty. Resolution of basic funding levels should help facilitate corporate hiring and business investment just at the moment the US could use the shot in the arm.

The fights over fiscal policy and the budget have always been messy and divisive. There have been 17 shutdowns since 1976 and since the Eisenhower Administration, there have been periodic threats not to lift the debt ceiling to force legislative action [refer to Chart 3].

Arguably, given the US fiscal position, the risks and consequences of these political battles are notably higher; yet most societies struggle to manage political equities in times of austerity.

In the case of the US, all the gory details play out for the world to see – and it hasn’t been pretty to watch. We may not see a replay of this scale in 2014, but the battles are likely to remain a feature of the US landscape well into the next presidential election – because the stakes are high and the philosophical divide is deep.