The Economy

Priority Report

Republicans have a plan to force lower spending without risking default.
Economist StaffMay 21, 2013

Austerity may be weighing on America’s economy, but it has its consolations. On May 14, the Congressional Budget Office sharply revised down its estimate of the budget deficit this fiscal year, to $642 billion or just 4% of GDP, from 5.3% in February. That would put it at less than half its recent peak of 10.1% in 2009.

Several factors explain the receding red ink: the economy is improving; taxes rose sharply on January 1; the “sequester,” a series of across-the-board federal spending cuts, took effect in March; and there were several one-off surprises. Rich taxpayers shifted income (and taxes) into 2012 to avoid higher tax rates in 2013. Fannie Mae and Freddie Mac, mortgage agencies taken over by the Treasury Department in 2008, are to pay big dividends after accounting changes raised their net worth.

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But while shrinking numerically, the deficit looms large politically. On May 9 the Republican-controlled House of Representatives fired the latest salvo in America’s fiscal wars by passing the Full Faith and Credit Act. It would authorize the government, in the event it reaches its legal debt limit, to issue new debt solely to pay interest or redeem bonds held by the public or the Social Security Trust Fund. The bill is meant to avoid a repeat of 2011, when Republican resistance to raising the debt ceiling frightened investors into thinking America might default on its national debt. The ceiling was raised at the last minute, but Standard & Poor’s stripped the country of its AAA credit rating anyway.

Under the latest bill, the government would be forced to prioritize interest and Social Security payments ahead of other expenditure. This is appealing to conservative Republicans whom it would allow, in theory, to vote against a higher debt ceiling without being blamed for the cataclysm of a default. Moreover, it would accomplish what they lack the votes to do legislatively: drastically shrink government. Even with the latest improvement, revenues this year will only cover 81% of federal outlays (see chart). Unable to borrow, the federal government would have to decide on which commitments to renege: Medicare payments, food stamps, military salaries, disaster aid or something else.

Though less catastrophic than default, this would still be disruptive. Steve Hess of Moody’s Investors Service says the credit rating agency always assumed the Treasury Department would prioritize debt interest to avoid default, even without a legal obligation to do so. Both Moody’s and S&P say a political impasse that triggered prioritization would raise questions about America’s political stability and its creditworthiness. Moreover, the immediate cuts required under the scheme would probably send the economy into a swoon.

Democrats quickly labelled the bill “Pay China First,” since presumably Chinese bond holders would get their interest while the medical bills of sweet old ladies went unpaid. Barack Obama has promised to veto the bill in the unlikely event the Democrat-controlled Senate passes it.

Nonetheless, the bill gives Republicans a rejoinder should President Obama accuse them of toying with default, as he probably will when the time comes to raise the debt ceiling again. The government will formally reach the limit on May 19, but the Bipartisan Policy Center, a think-tank, reckons it can find additional borrowing room through accounting maneuvers, and the dividends from Fannie and Freddie, until October or November.

Republicans want spending cuts in return for raising the ceiling, but Mr Obama says he will not negotiate on the matter. One way out of the impasse would be a deal that trims spending along the lines Mr. Obama’s budget has already proposed, and raises tax revenue through the sort of reform Republicans want. The alternative, which unfortunately is all too plausible, is more fiscal brinkmanship.

© The Economist Newspaper Limited, London (May 18, 2013)