Debt Ceiling Battle: Tax Hikes or Spending Cuts?

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
May 24, 2011

IN THIS ISSUE:

1.  Recent Economic Reports Not Encouraging

2.  Uncle Sam Blows Through Debt Ceiling

3.  The Treasury’s Other Options

4.  Debt Ceiling Battle: Tax Increases vs. Spending Cuts

Introduction

On Monday, May 16, the US government officially exceeded the national debt ceiling of $14.3 trillion.  Nothing much happened, of course, because Treasury Secretary Geithner had already announced that the Treasury Department could implement various emergency measures to fund the government and avoid default until around August 2.

Since most Americans have no idea what these emergency measures are, I thought it might be interesting to briefly discuss them.  Basically these emergency measures include robbing cash from various government trust and pension funds to keep the US from defaulting on its debts and day-to-day obligations.  You may be surprised at the many ways Treasury Secretary Geithner has to keep the government running until the debt ceiling is raised.

On the subject of raising the debt ceiling, the battle lines have clearly been drawn among Republicans and Democrats, including President Obama.  Republicans vow that there must be at least $2 trillion in spending cuts in order to raise the debt ceiling from $14.3 trillion to $16.5 trillion.  Democrats, on the other hand, want to raise taxes on the “rich” and on the five largest oil companies.  A huge fight lies ahead between now and August 2.

Following that discussion, I will attempt to explain why the payment of Social Security benefits does not increase the national debt, at least not anytime soon.  This is a subject of great controversy and misunderstanding, and I will try to clear it up for my clients and readers.

But before we get to those hot topics, I will review the latest economic reports which, on balance, continue to indicate that the economic recovery is slowing down. 

Recent Economic Reports Not Encouraging

The Index of Leading Economic Indicators (LEI) fell 0.3% in April following nine consecutive months of gains.  For March, the LEI was revised up to 0.7% but the decline in April was worse than the pre-report consensus expectation.

On the unemployment front, initial claims for new unemployment benefits continued to run above 400,000 per week through the week of May 14.  The official unemployment rate rose to 9.0% in April from 8.8% in March.  The good news is that the latest report showed that non-farm payrolls increased by 244,000 in April, but there are still 13.7 million Americans out of work.  Some 8.6 million people are working part-time jobs because they cannot find full-time work.  Another 2.5 million unemployed were not counted since they had not looked for work in the last four weeks.  So the real unemployment rate remains above 13%.

On the bright side, retail sales were up 0.5% in April, about in line with expectations.  The University of Michigan Consumer Sentiment Index was slightly higher in the first week of May.  The ISM manufacturing index fell slightly in April to 60.4 but still beat the pre-report consensus.  The ISM services index, however, plunged from 57.3 in March to 52.8 in April.

On the housing front, the news was once again disappointing.  Sales of existing homes fell to 5.05 million units in April, well below the consensus estimate of 5.25 million units.  Housing starts fell from 585,000 in March to 523,000 in April.  Building permits fell to 551,000 in April, down from 574,000 in March.

The second estimate of 1Q GDP will be out on Thursday.  The first estimate showed the economy growing only at a 1.8% annual rate, and the pre-report consensus is unchanged to slightly higher.    

Uncle Sam Blows Through Debt Ceiling

On Monday, May 16, the US government officially exceeded the national debt ceiling of $14.3 trillion.  Nothing much happened, of course, because Treasury Secretary Geithner had already announced that the Treasury Department could implement various emergency measures to fund the government and avoid default until around August 2.

Since most Americans have no idea what these emergency measures are, I thought it might be interesting to briefly discuss them.  Reportedly, Geithner’s first emergency action was to tap into two government employee pension funds to free up cash.  But Geithner had already initiated other emergency actions even before the official debt ceiling was exceeded.

On May 6, the Treasury stopped issuing State and Local Government Series Treasury securities until further notice.  These special securities can be bought by state and local governments to assist them in complying with federal tax laws and Internal Revenue Service arbitrage regulations when they have cash proceeds to invest from their issuance of tax exempt bonds.

The steps Geithner announced on May 16 reportedly will free up $12 billion over two months in part by halting new investments in the Civil Service Retirement and Disability Fund and redeeming existing investments in that fund.  Geithner also suspended the daily reinvestment of Treasury securities held as investments by the Government Securities Investment Fund of the Federal Employees’ Retirement System Thrift Savings Plan.

Geithner also has the one-time option of not reinvesting securities that mature in the federal employee retirement fund, as the Treasury usually would do.  In that situation, the Treasury could free up $67 billion more in headroom on June 30, when some of those securities mature.

Along similar lines, Geithner announced on May 16 that he was slowing investment in the Government Securities Investment Fund for federal employees’ retirement, which will create another $130 billion.   Of course, all of the money and securities Geithner is taking from the government pension entities will be paid back just as soon as the debt limit is raised.

Geithner warned that while these steps have been used in the past when Congress has lagged on raising the debt ceiling, they would be “less useful” this time around. The reason: The government is borrowing and spending at a record rate, and thus each emergency action buys less time than it had in previous debt ceiling battles.

In what was apparently his last task on May 16, Geithner issued a letter to Congress urging lawmakers to raise the debt ceiling.  Here is the last paragraph of that letter:

“I have written to Congress on previous occasions regarding the importance of timely action to increase the debt limit in order to protect the full faith and credit of the United States and avoid catastrophic economic consequences for citizens. I again urge Congress to act to increase the statutory debt limit as soon as possible.”  [Emphasis added.]

Though Geithner’s language was stark, his announcement lent little urgency to talks on raising the debt limit.  In fact, the panel of debt ceiling negotiators led by Vice President Biden that is supposed to meet twice a week until an agreement is reached didn’t bother to meet at all last week.  Everyone knows they have a 10-week timeframe to work out a deal. 

Geithner’s moves have been telegraphed well in advance, and were designed to calm markets that many worry could tumble if investors come to believe the debt ceiling will not be raised.  The Dow Jones closed down only 47 points on May 16 as the debt limit was breached.  Bond yields ticked only modestly higher.

 Ten Years, Ten Increases to the Debt Limit 

The Treasury’s Other Emergency Options

If Geithner is to be believed, the emergency actions noted above would keep the government from defaulting until August 2.  The exact date will vary slightly based on tax revenues between now and then.  There are also some other emergency options the Treasury has at its discretion to buy some additional time.

There is the so-called Foreign Exchange Stabilization Fund that exists primarily to stabilize currency rates, if needed.  The Treasury could dip into this seldom-used $50 billion fund and take out the US dollar balance which is currently apprx. $23 billion.  Interestingly, this Fund was last used as a backstop to guarantee money market mutual funds during the financial crisis from September 2008 to September 2009.

The Treasury could also cut issuance of longer-term government debt and rely more heavily on short-term “cash management bills” to gain more day-to-day control over debt outstanding. Cash management bills are typically issued for days instead of normal Treasury bill maturities of four weeks to one year.  This option doesn’t buy a lot of time, but it could be used if necessary.

Treasury secretaries in the past have halted sales of US savings bonds to the public during debt limit impasses, but Geithner argues that this would be of little or no use. It would not free up borrowing authority and it would only prevent small amounts of new debt from being issued. Savings bond sales increase the debt by less than $220 million per month on average, giving this measure little potency during a time of trillion-dollar deficits.

The Federal Financing Bank (FFB) can issue up to $15 billion in debt on behalf of other government agencies that is not subject to the debt limit.  So the Treasury could exchange FFB debt for other debt to reduce the total amount subject to the limit.  

The government could raise money by selling off chunks of companies it bailed out under its $700 billion Troubled Asset Relief Program (TARP).  However, Geithner has said this was not a viable option because taxpayers could end up suffering losses from a "fire sale" of financial assets.  But it’s still an option if Congress doesn’t raise the debt ceiling by August 2.

The Treasury recently announced that it is considering selling down its mortgage-backed securities portfolio at a rate of $10 billion per month.  It could move ahead with this plan.  Then there is the option of selling US gold holdings, which could create havoc in the metals markets.  Geithner said that option is unlikely to be used as it could undermine confidence in the United States.

The final point of note is that the Treasury Secretary can hope for higher tax receipts.  The Treasury was able to stave off its debt limit reckoning by about a month because the April tax filing season produced higher than expected receipts.  In the first six months of fiscal 2011 they were up about 7%, or about $66 billion, from a year earlier, but they fell $2 billion in March, as new cuts in payroll taxes and business tax credits ate into revenue.

The Debt Ceiling Battle: Tax Increases vs. Spending Cuts

When I last wrote about the debt ceiling two weeks ago, we were just beginning to hear the White House, Geithner and some leading Democrats call for raising taxes on the so-called “rich.”  Today such talk of raising taxes on those individuals making over $200,000 and those families making over $250,000 a year is widespread.

Now in addition to raising taxes on the rich, the Dems want to eliminate tax incentives for the five largest oil companies.  The tax incentives for Exxon Mobil, Conoco Phillips, Shell, Chevron and BP are estimated to be around $20 billion a year, although there is widespread disagreement about this number.  The Dems including Senator Harry Reid are demanding that ending these tax incentives must be included in any deal to raise the debt ceiling.

The Republicans in the House voted down the Dem’s plan to raise taxes on the big oil companies last week, but Harry Reid promises that this issue will come up again before the debt limit is raised.

Amazingly, the Dems are arguing that ending these oil company tax incentives will cause gasoline prices to go down!  This just proves once again that these people will say anything, even if they know it’s not true.  The truth is that if the government removes tax breaks of $20 billion (or whatever the number is), it will result in higher gas prices.  The oil companies will simply pass it on to consumers.

By the way, it might interest you to know that most of the so-called tax breaks for the big oil companies are also enjoyed across most other industries as well.   The US tax code has long allowed corporate taxpayers the ability to recover costs and to be taxed only on net income. These cost recovery mechanisms, also known in policy circles as “tax expenditures,” should not be confused with subsidies, which are direct government spending.

You may recall that Obama, Geithner and some leading Democrats want the debt ceiling raised from $14.3 trillion to $16.5 trillion to supposedly get us through the end of next year.  House Speaker Boehner has vowed that in order to sign-off on the $2.2 trillion increase in the debt ceiling, he will require spending cuts of at least $2 trillion.  As I wrote two weeks ago, I don’t think he will get anything remotely near $2 trillion in cuts.

The battle lines are drawn: Tax increases on the “rich” and Big Oil versus spending cuts.  How might this play out?  The Obama Administration and Geithner are clearly threatening the Republicans in the media by saying it will be their fault if the debt ceiling is not raised.   Here’s an excerpt from a speech Geithner gave at the Harvard Club in New York last week:

“If Republicans try to impose that plan [spending cuts] on this country as a condition for raising the debt limit, then they will own the responsibility for the first default in our history, with devastating damage to the nation.”

We can argue about whether those families making over $250,000 should have their taxes raised.  Likewise, we can argue about whether oil companies should have any tax incentives at all.  The problem, in my opinion, is that now is not the time to do either.  Raising taxes and increasing the price of gasoline when it’s already above $4.00 per gallon in some areas is the last thing you want to do at a time when the feeble economic recovery is slowing down.

It will be interesting to see how this game of chicken plays out between now and August 2.  In case you’re wondering why we’re running trillion-dollar deficits, take a look at this chart that shows our federal revenues versus federal spending for fiscal 2010.  The budget deficit hit a record $1.3 trillion.  But that will be exceeded for fiscal 2011 as the deficit this year is now estimated to top $1.6 trillion.

  F2010 USA Inc. Revenues + Expenses at a Glance  

Republicans’ and Democrats’ Latest Ploy

Just as I am about to hit the “send” button for today’s E-Letter, Time magazine reports that the Republicans in the House of Representatives are preparing to hold a vote on a measure to raise the debt ceiling by $2.4 trillion with no strings attached (ie – no spending cuts).  The GOP leaders in the House anticipate that this measure will fail unanimously, with not a single vote in favor.

The Time article goes on to suggest that the Democrats in the Senate are planning a similar vote on raising the debt ceiling, also with no strings attached (ie – no tax increases).  If so, they would expect such a “clean” bill vote to fail unanimously.

So why would both parties be planning to vote on two separate measures to raise the debt ceiling when both are expected to get zero “yes” votes?  It’s all politics folks!  Better put, it’s just a shenanigan so that everyone in Congress can tell their constituents back home that they voted “no” on raising the debt ceiling. 

These sham votes against the debt ceiling increase will, in their minds, clear the way for both sides to compromise and meet somewhere in the middle.  The thinking would be: Well, the no votes showed us just how far apart both sides are, so we all had to compromise to keep the government from defaulting on its debt.   How stupid do they think we are?  As I wrote two weeks ago, the answer to that question is – VERY STUPID!

You can bet that the compromise to come in the weeks ahead will look something like this: The Democrats will agree to waive their tax increases on the “rich” and the Republicans will cave on all or most of their spending cuts.  If so, it’s all going to play out almost exactly as I predicted two weeks ago, and just as it has many times in the past. 

The debt ceiling will be increased.  The only question is by how much.  It’s business as usual in Washington, on both sides of the aisle.  You can read the Time article in the links below.

Wishing you all a great Memorial Day holiday,

Gary D. Halbert

P.S.  Finally, on a personal note, Debi and I will be traveling to Italy next Tuesday, a week from today, to officially celebrate our 25th wedding anniversary.  We have plans to visit Venice, Florence and Rome, plus spend a couple of days in Tuscany when we meet up with John Mauldin and some of his family.  I have not been to Italy before, so this should be interesting.

SPECIAL ARTICLES

Debt Limit Smackdown: Chicken vs. Rope-a-Dope
http://www.realclearmarkets.com/articles/2011/05/23/the_debt_limit_smackdown_chicken_versus_rope-a-dope_99034.html

Biden talks seen as last hope for debt ceiling deal
http://www.reuters.com/article/2011/05/23/us-usa-debt-biden-idUSTRE74L31620110523

Time article on upcoming debt ceiling “No” votes
http://swampland.time.com/2011/05/24/house-republicans-clean-debt-ceiling-vote


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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