After the Debt Ceiling Showdown, What Comes Next?
Aug 08, 2011
Publisher: Milken Institute

Several of the Milken Institute's top experts sat down to analyze the implications of the debt-ceiling deal and subsequent rating downgrade. Peter Passell, editor of The Milken Institute Review, moderated a group that included Brad Belt, a senior managing director of the Milken Institute and head of the organization's new Washington office; Milken Institute economic policy fellow Jared Bernstein, who served as chief economist and economic adviser to Vice President Joe Biden from 2009 to 2011; and Milken Institute senior fellow Phillip Swagel, who was the assistant secretary for economic policy at the Treasury Department for the last two years of the G.W. Bush administration. Here are some highlights from their discussion.

Peter Passell: What (if anything) do we think the debt ceiling deal accomplished?

Brad Belt: The good part, of course, is that it removed the specter of default, at least for the time being. The bad (or at least, not so good) was that it kicked the can on entitlement and tax reform issues, only modestly reduced the deficit and debt-to-GDP trajectory, and ultimately provided little clarity to business, consumers and investors about the direction of fiscal policy. The process itself can only be described as ugly - and ugliness will no doubt be replayed in the deliberations of the congressional "super committee" and, after the election, in the next debt ceiling debate.

Phillip Swagel: The debt ceiling had to be raised, and while the process wasn't pretty, they did manage to do it. I also think the debate furthered the conversation about fiscal sustainability. It was a limited step, but a beginning. I'll echo Brad on the issue of the process, though. I would've thought that President Obama had a big incentive to avoid the drawn-out debate and to cut the uncertainty that's affecting business and consumer confidence. But maybe the Republicans just wouldn't play along - it's hard to say.

Jared Bernstein: Agreed: The main accomplishment was getting the threat of default behind us. But that may turn out to be a pyrrhic victory. In the wake of their perceived success in what was truly a dysfunctional process, Republicans are suggesting that the next debt ceiling debate is going to be a lot like this one. In fact, Sen. Rob Portman (R-OH) published an op-ed this morning saying that, from now on, every increase in the debt ceiling has to be matched dollar-for-dollar by spending cuts. To me, that enshrines dysfunction.

Brad Belt: The agreement put a modest dent in the future trajectory of budget deficits. But we're still on a glide path toward a debt-to-GDP ratio of about 100 percent. It clearly did not deal with the critical issues of the day. Nothing was done to curb entitlements, which is where the long-term deficit pressure is really coming from. Nor did it address fundamental tax reform, which we're going to have to manage in some fashion - and not just by raising rates as a way of generating revenue.

Peter Passell: The deal was supposed to relieve uncertainty in financial markets. Did it?

Brad Belt: If the last couple of days are any indication, it hasn't calmed the markets in any meaningful way. There's still a lot of uncertainty, bordering, I think, on outright fear. It was widely understood that the direct effect of budget cuts would be negative for GDP growth in the near term. This (modest) effect could have been more than offset if the market had perceived the agreement as the beginning of a successful strategy for managing deficits in the long term.

Jared Bernstein: It looks to me like after the crisis ended, the markets woke up, rubbed their eyes, looked around and realized that the economy is really quite weak. That underscores a key point about this debate: While policymakers were just obsessed the debt and deficit issues, the rest of the country was understandably focusing on what's really important right now. Which isn't the budget deficit - it's the jobs deficit.

Phillip Swagel: I agree with Jared that an opportunity was lost to do more than address the deficit - to combine a credible deficit reduction with expansionary near-term fiscal action. There are lots of ways to that; a payroll tax cut would be one example. But we've gotten into this political dynamic in which distrust of the administration drives decisions. Republicans are saying, "You know and we know that you're running for re-election on not doing entitlement reform; a central pillar of the Obama campaign is going to be demagoguing on Medicare. And we're not going to make it easy for you."

Jared Bernstein: Phill may be accurately describing what Congressional Republicans are thinking. But let's be very clear that the source of the deep dysfunctionality of the deficit debate wasn't the administration, wasn't the Democrats, wasn't moderate Republicans. It was the extreme right wing of the Republican Party - particularly those in the House who simply refused to negotiate from day one.

Peter Passell: How is the S&P downgrade of U.S. sovereign debt likely to play out?

Brad Belt: The impact is more symbolic than anything else, but obviously there is power in symbolism. It strikes me as a bit disingenuous for governments to complain about the ratings agencies' actions since regulators were the ones who anointed them as arbitrators of credit. Still, the downgrade is problematic in several respects. It reflects a view about the political process rather than the wherewithal of the US meet its obligations. And I don't think the ratings agencies have much of real value to contribute in the way of political analysis. At end of the day, does anyone believe truly believe that that France, Germany and the UK are less likely to default than the US?

Phillip Swagel: The downgrade should be taken seriously even though it was not based on new information. Market participants are well aware that the U.S. fiscal trajectory is not sustainable, but have assumed that a solution will be reached -- no one could say quite what that solution would be, but there was broad confidence that one would be found. The fractious debt ceiling debate called this into question. It's not a huge question--yet. Nonetheless, the downgrade is a symptom that should not be ignored.

Jared Bernstein: As I've written on my blog there's no doubt that the self-inflicted damage caused by the debt ceiling debacle is huge. But S&P never should have taken us down a notch. Their job is to judge whether the US government is a creditworthy borrower, which of course it is. The markets, by the way, agree with me: Treasury rates barely budged in the wake of the downgrade. That said, S&P's critique of our dysfunctional politics and inability to get revenues in the deficit reduction deal makes sense.

Peter Passell: Brad suggested a few minutes back that the short-run impact of the spending cuts in the accord would be counterproductive to economic growth. Does everybody agree?

Jared Bernstein: In the first year, the Congressional Budget Office says the cuts will total about $21 billion. That's something like one-tenth of 1 percent of GDP. So it was certainly a move in the wrong direction in terms of stimulus, but not enough to make much of a difference. It's 2013 where the fiscal impact makes me nervous. If the "super committee" [which must come up with a plan for the next round of cuts by November] deadlocks, you could see a negative fiscal impulse in 2013 in the $80 billion+ range.

Phillip Swagel: I agree with Jared. The initial-year cuts are small, so I don't think they"ll be very harmful. And the agreement could have a positive effect on private spending if it's taken as a sign of seriousness on deficit reduction. But this was still a lost opportunity. In any event, it's not too late: If the employment and growth numbers remain weak in the coming months, we may be hearing more about a payroll tax cut for the short term combined with fiscal tightening over time.

Brad Belt: The modest negative fiscal stimulus impact on the initial cuts could have much more than offset by business investment spending if the markets thought that the deal had really changed the nature of the debate. But there's reason to believe it didn't - that it didn't generate a new level of comity, a greater inclination toward bipartisanship. Markets are saying, "We're waiting for some clarity and certainty. We didn't get that."

Jared Bernstein: At a time like this, I think the market's view becomes a Rorschach test: People attribute whatever motives they want to the market. So let me take a shot. I don't think markets are responding so much in the way Brad described. Interestingly, even as we were looking over the abyss at default, Treasury yields remained extremely low. And dollars continued to flow into the country from across the globe because, even then, it was the judgment of the market that the United States was still the safest haven. Now, with the debt ceiling debate behind us, yields are ever lower. So I don't see the clouds of uncertainty in the bond market that Brad described. Brad may have a better case with the stock market. But I think those problems have a lot more to do with an economy that's bumping along the bottom.

Brad Belt: Worries about the deficit and worries about the economy are connected. If we can't get our long-term fiscal house in order, it's going to be difficult to generate sustained growth. We're between a rock and a hard place now. I think market weakness is the reflection of the weakness of the underlying economy, which is in part driven by concern about the direction of policy and politics.

Phillip Swagel: I found it striking that Treasury yields didn't go up, except at the very, very short end as the debt ceiling deadline approached. This says to me that U.S. Treasuries are still seen as a safe haven - that we still have time to deal with the fiscal problem. But the story could be different next year, or the year after.

Peter Passell: The super committee was created on the premise that a small number of members of Congress would have an easier time hammering out a long-term debt deal. Do we think that the politics of the super committee will be much different than the politics of the whole Congress?

Jared Bernstein: The smart money is probably betting that the super committee deadlocks on partisan lines. Democrats on the committee will certainly want tax revenues to be part of the second tranche of deficit cuts that the super committee must come up with by Thanksgiving. But Republicans are only going to appoint members committed to resisting any tax increase. And that seems to me to be a recipe for gridlock - which means that the automatic spending cuts set out in the agreement in case of a stalemate will be triggered in 2013.

Phillip Swagel: That's the most likely outcome. But I'm a little bit more optimistic. Sens. Durbin (D-IL) and Coburn (R-OK) came from very different places, but both said "yes" to the deficit reduction compromise proposed by the Bowles-Simpson commission. So that gives me hope that there are thoughtful politicians who look over the horizon and see they need to act. I'm not banking on it. But there is reason to still hope.

Brad Belt: I would also bet on a deadlock. But Phill is right that there's some reason to hope for a 7-5 or 8-4 vote in favor of some sort of grand bargain along the lines of the Gang of Six or Bowles-Simpson commission proposals. But even if the super committee comes up with 2-for-1 or 3-for-1 spending cuts to tax increases, getting the deal through Congress - particularly the House - would be problematic.

Jared Bernstein: To break a 6-6 deadlock, John Boehner and Mitch McConnell would have to go back on a pledge not to raise taxes. That's not impossible. Nor is it impossible that a plan with some tax increases could survive up-or-down votes in Congress, because the alternative has been fairly effectively constructed to make both parties nervous. The stalemate trigger would force $1.2 trillion in spending cuts, split 50/50 between defense and other discretionary programs that have already taken a big hit. That threat might force a deal, but I'm skeptical.

Peter Passell: I can see the Republicans being nervous about defense cuts. But what other programs at risk matter this much to Congress?

Jared Bernstein: Half of the $1.2 trillion in cuts triggered would hit transportation, infrastructure, research, education, community services, child care - stuff that Democrats typically want to protect. But the opportunity to really cut into defense could be tempting.

Brad Belt: The interesting dynamic there is how the parties set priorities. Social Security, Medicaid, veterans' benefits, Pell Grants, food stamps and Supplemental Security Income are all exempt from the trigger. But all the other programs dear to one constituency or another would be at risk. The military-industrial complex is already gearing up to try to avoid that outcome. So there is going to be a lot of pressure to avoid the trigger.

Jared Bernstein: Let the record show that Brad just said "the military-industrial complex"!

Peter Passell: This deal and the process leading up to it certainly were not looked upon with favor by Europeans and Asians. Do we think that will lead to any lasting damage to Treasury securities and, more generally, to U.S. financial markets as a safe haven?

Jared Bernstein: I'm a bit worried that we've already done lasting damage. And if this debate is seen as a precedent for handling debt ceiling increases in the future, I'll worry a lot more. Yet Republicans are openly talking about replicating the battle we've just had in order to squeeze more spending cuts. Any objective person would agree this is a terrible way to do budgeting. Saying this process should serve as the precedent for future agreements is no different than you or I saying in the middle of a restaurant meal we ordered that we're just not going to pay for it. If we go that route, global markets have a right to not to take us seriously.

Phillip Swagel: This is one of those problems without a solution until after the election.

Peter Passell: Does anybody think this crisis could lead to the replacement of the dollar as a reserve currency?

Jared Bernstein: That's apparently what renowned economist Vladimir Putin was calling for yesterday.

Brad Belt: It certainly did nothing to enhance the global view of the U.S., or strengthen the position of the dollar. But the question is whether there is there a better alternative to the dollar, and the answer, clearly, is no. The eurozone is dealing with even more fundamental challenges than the U.S., and it is by no means certain that the euro will survive in its current form. And I don't believe there is sufficient global trust in the yuan to allow it to become a store of value.

Phillip Swagel: It's unlikely the dollar will lose reserve status. But if the dollar does lose its special place, we'll look back and see the debt ceiling mess as the beginning.

Jared Bernstein: I totally agree. The only thing I would add is that in the short run, a weaker dollar would actually help the U.S. by making our exports more competitive. But that's really a different point, one that has more to do with the business cycle than with the structural question you're raising.

Peter Passell: So there might be a silver lining here? The debt ceiling mess might lead to a depreciation of the dollar, which helps exports and stimulates the economy?

Jared Bernstein: Well, that would be fine until we had to start kicking interest rates through the roof in order to service our debt. There are a lot of moving parts here.

Phillip Swagel: A weak dollar would boost exports and growth, but we wouldn't want to depend on it. We need to find ways to grow on our own, not based on external demand.

Peter Passell: Thanks, everyone.