In Debt We Trust

How do we avoid default at this stage as a nation? Can the two parties arrive at a reasonable solution that not only gets us past this crisis but also leaves us with a better balance sheet than before?

I just read an interview over at Global Post[1] that makes a lot of sense. Unfortunately, it does sound like a two phase solution would be most fruitful at this stage since tempers are so high after weeks of negotiating. The current proposals by Senator Reid and Speaker Boehner are farther from the compromise solutions than is resolvable in the time we have before default. The markets are already reacting and are likely to continue suffering so long as no clear path emerges.

One proposal I've read about is a clean bill including nothing but a debt limit increase. At this point, there would still likely be bipartisan support for such a bill and it would buy time to continue negotiating the finer points of deficit reduction without the stress of a looming deadline. Is this workable? Perhaps, though as the ratings agencies stated it might still result in a rate reduction and thus higher cost for future borrowing.

[1]Debt Crisis interview

Ready to debtonate

Have you heard of the debt ceiling debates? Yes? Okay - skip to paragraph two. So there's this limit called the "debt ceiling" that defines how much money the treasury can borrow via bond and similar instruments to pay for the programs and spending authorized by congress and signed into law by the president. We keep having to raise this limit because we're spending money faster than we're taking it in. On or around August 2nd we will reach the current limit and then be able to pay for about half of the stuff that we're currently doing without any new borrowing.

The debate has faltered numerous times over the last few months. There are several sticking points, or lines in the sand. Most revolve around a strong desire to reform our country's financial situation as a stipulation for raising this debt ceiling. Here are the two main issues I see at the moment:

1. Tea Party Republicans insist the limit be raised only with spending cuts attached, not with any increased tax revenue from current levels
2. President Obama, Senator Reid, and now Representative Pelosi, among others, want the limit raised enough that we won't have to debate this again before the 2012 election

The first has been a major problem for negotiations. Both the President's commission on the deficit and the recent "Gang of Six" proposal formed by three senators from each of the major parties includes additional tax revenue. When you have a cash flow problem, there are two options - reduce outflows and increase inflows. You can do one, the other, or both.

The second issue means that the volume of the money being discussed is very large, potentially up to $4 trillion over the next ten years. The driving force behind this requirement could be political - not wanting to have this issue come up again closer to the election. It could also be an efficiency argument - why have the same debate multiple times? Perhaps it's also tending on the perfectionist side - let's get the right answer rather than the quick one. In any case, I do believe that it is in the country's best interests to have a broader solution than a hack job, but the partial step is better than nothing at this stage.

In the case of a balance sheet as large as our nations, it's very difficult to choose only one of revenue or spending cuts without significantly changing the playing field. Rather, making smaller changes to both outflows and inflows helps keep the system more predictable and allows us time to see the impact of the changes. Several polls have shown that the majority of U.S. citizens favor a compromise that includes some of both. It really depends on the wording of the question, of course.[1] Still, the polls I've checked have shown that Democrats and independents are largely agree that tax increases should be part of the package. Republiicans are generally more in favor of cut only, but not by a large margin.[2]

How will this play out? In one scenario we could get a debt limit increase with only minimal cuts and some ongoing debate on the overall debt. In another, the negotiations that have been underway somehow reach a compromise in time for a vote before the deadline. It's also possible that the limit isn't raised in time and some payments stop going out. The investment world is getting more and more worried about this third option if quotes from economists and fund managers are any indication. Legislators are scrambling over the weekend to come up with something solid to avoid a massive negative market on Monday.

Can they do it? We've seen eleventh hour deals already this year and might be able to get one again. Still, you won't find me playing Russian roullette any time soon.[3]

[1]Poll divide

[2]CNN/ORC July 18-21 poll

[3] "The Tea Party is effectively playing Russian roulette with the bond market and they will, with certainty, lose," said Christian Cooper, head of U.S. dollar derivatives trading in New York at Jefferies & Co. Jefferies is one of 20 primary dealers that trade with the U.S. Federal Reserve.