The fiscal cliff “catch-22”

Additional Congressional actions

Much to the consternation of policymakers, the impact of ARRA and QE1 did not achieve the intended purpose. The goal was to provide a stop gap that would fill the void temporarily resulting from a slowdown in private sector spending. The assumption was that private sector spending would accelerate and move back to more normal levels once the fear of recession subsided. The reality is that the private sector continued to take the prudent approach by paying down debt and accumulating savings.

In an effort to buy more time, in December of 2010 Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which extended the Bush tax cuts for an additional two years. As a result of the collective impact of these various stimulus measures, U.S. debt levels had soared by the summer of 2011 to levels that were simply unsustainable going forward. The chart below sets up the dilemma faced by legislators in 2011.

In 2011 U.S. debt had climbed to the point where it was close to equal with total GDP. Deficit spending was out of control and the cost of fiscal stimulus was rapidly becoming a serious problem. The debt ceiling increase was the focal point of a Congressional battle that was bringing the country close to default on scheduled payments for the first time in the country’s history. Finally, a compromise was reached and President Obama signed the Budget Control Act of 2011 into law on Aug. 2, 2011 allowing an increase in the federal debt ceiling subject to provisions that would address the debt and deficit in 2013.

Even though the Budget Control Act of 2011 was enacted in time to avoid default, on Aug. 5, 2011 — just a few days later — Standard & Poor’s downgraded the United States credit rating for the first time in the country’s history. The market’s response to the Congressional battle over the debt ceiling and the subsequent credit downgrade resulted in a sharp sell-off in stocks. On Aug. 1, 2011 the S&P 500 closed at 1286. On Aug. 9, 2011 the S&P put in a low of 1101, a drop of almost 15% in six trading days. The following excerpt explains Standard & Poor’s reason for the credit downgrade:

The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.

More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on Apr. 18, 2011.

Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.

The outlook on the long-term rating is negative. We could lower the long-term rating to 'AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.

Standards & Poor’s assessment proved particularly prophetic as Congress did indeed struggle to reach a broader accord. After several attempts to reach agreement, the final version of the Budget Control Act specified an initial debt limit increase in two phases totaling $900 billion. In exchange for the concession on the debt ceiling the bill specified a total of $917 billion in spending cuts over 10 years. 

An additional provision of the Budget Control Act allowed the President to request another increase in the debt ceiling of $1.2 to $1.5 trillion subject to a congressional motion of disapproval. In exchange for the additional increase provision, the Budget Control Act called for spending cuts equal to $1.2 trillion, again spread out over 10 years. 

The Joint Select Committee on Deficit Reduction, more commonly referred to as the “Super Committee,” was formed to identify specific spending cuts equal to the $1.2 trillion debt ceiling increase provision. The Super Committee was a bi-partisan committee and after months of work trying to agree on specific spending cuts, the committee concluded their work without arriving at an agreement.

The impact of the Super Committee’s failure to arrive at specific cuts was anticipated.  If the Super Committee failed to achieve their mandate, then Congress could grant the additional $1.2 trillion debt ceiling increase by simply not acting to disapprove the request, but in so doing across the board spending cuts referred to as “sequestration” cuts would be implemented. 

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