US Economy 2013: If 'Fiscal Cliff' Is Avoided, What About The Debt Ceiling?

U.S. fiscal talks have progressed in a stop-and-go fashion. But at this point, the looming “fiscal cliff” is no longer the biggest threat, because we now know what’s on the other side of it -- the debt ceiling.

Even if Congress and the White House are able to pass temporary “patches” before year's end to prevent some $600 billion in automatic tax hikes and spending cuts from damaging the economy, a short-run political compromise to avoid the fiscal cliff is not likely to adequately address the long-run economic imperatives facing the country.

Unless it’s dealt with in the lame-duck Congress, the U.S. will hit another debt limit come February.

“I don’t think just any deal will remove the uncertainty,” said Richard Kovacevich, former CEO of Wells Fargo (NYSE:WFC). “If debt limit is not part of this deal, we just shift from the fiscal cliff to the debt ceiling debate.”

Deal Or No Deal?

After a brief stretch of several days in which negotiations seemed to be humming along nicely, they've stalled again.

“The American people are pretty tired of bickering,” said Michael Robinson, an executive vice president for Levick Strategic Communications and a former White House spokesperson. “I think both sides have done political calculations and that the longer this goes on, the worse it is for everybody.”

The public mood is sour about both sides, a new Washington Post-ABC News poll found. Should the talks break down, 47 percent say they would blame Republicans; 31 percent say they are more likely to point the finger at President Barack Obama. But 18 percent, a growing number, say that they would hold both sides equally culpable.

“One poll says we blame the president, another poll says we blame the Republicans. The fact is, everybody is getting dragged down by this,” Robinson said.

Ethan S. Harris, North American economist for Bank of America Merrill Lynch (NYSE:BAC), said the best outcome is a resolution of all the cliff items before year-end, including a long-term extension of the debt ceiling and a well-designed process for negotiating entitlement and tax reform. However, he sees only a roughly 20 percent probability of this.

The most likely scenario is a multi-stage fix. Politicians only agree on part of the cliff by year-end, and agree to delay every other part of the cliff for several months to allow more time to negotiate. Given the wide gap in views, the short time frame, the size and complexity of the cliff, Harris sees a roughly 60 percent chance that it will take more than one try to resolve.

Of course, there’s also a one-in-five-chance of going over the cliff -- either deliberately, as a way to reset the starting point for negotiations, or accidentally, if a last-minute deal falls apart.

“I am optimistic that they will patch something together to get us past the cliff,” said William Isaac, former chairman of the Federal Deposit Insurance Corp., currently a senior managing director of FTI Consulting. “But I’m not optimistic about a really significant deal getting done, one that will really put us on the path of recovery and economic growth.”

“If we don’t get the economy growing again and we try to do those things [raise taxes and cut spending], we are going to have riots in the street,” Isaac said.

Fear the Debt Ceiling, Not the Fiscal Cliff

So here we are again.

The debt ceiling is currently capped at $16.4 trillion, the rate established during last year's showdown. The Bipartisan Policy Center predicts the U.S. will hit that limit by mid-February, posing the threat of government shutdown and another congressional battle.

The political brinksmanship that marked the debt ceiling fight in 2011 earned the U.S. its first-ever credit downgrade, rocked stock markets and eroded confidence in Congress.

Last summer’s debt ceiling fight will ultimately cost taxpayers $18.9 billion over 10 years, the Bipartisan Policy Center has found. That's largely the result of the government's having to borrow at higher interest rates during the standoff, a time when investors feared the possibility of a default.

Another debt ceiling fiasco could cost the government even more money and possibly lead to further credit rating downgrades.

The U.S. currently still enjoys the “gold standard” of triple-A ratings from two of the three rating agencies -- Fitch and Moody's. Standard & Poor's trimmed its U.S. credit rating by one notch in August 2011 to AA+, citing political brinkmanship that was preventing agreement on raising the debt ceiling -- without which the government can't pay its bills -- and a longer-term plan to reduce borrowing. It warned earlier this year that a further downgrade was possible in the absence of a debt deal.

If lawmakers can’t come up with a deal that truly addresses the imminent issues to avoid a recession next near, as well as one that provides long-term fixes to the huge national debt, then “I’m 90 percent sure that Moody’s or Fitch will downgrade us to at least where S&P is and maybe S&P will go down another notch,” Kovacevich said.

A downgrade by Moody’s or Fitch would cause a lot of trauma that the downgrade by S&P didn’t.

Isaac explained that there are many companies and institutions that may only invest in triple-A rated securities or have serious limitations on how much they can invest in something that isn’t triple-A. If two of the three rating agencies strip the U.S. of its triple-A rating, then these organizations can no longer invest in U.S. securities.

“I guess we’d have to sell more to foreigners and there’s going to be a limit to their appetite,” Isaac said.

More than a year has passed, and S&P's historic move now looks like a non-event. Long-term interest rates are sharply lower. The interest rate, or yield, on 10-year Treasury notes has fallen from 2.58 percent on Aug. 5, 2011 to 1.8 percent Thursday. The Dow Jones Industrial Average, which dropped 635 points in panicked selling the first day of trading after the S&P announcement, reversed course and is now up more than 1,160 points.

“Although last time nothing much happened,” Kovacevich said. “This time, much more could happen.”

Rival rating agencies Moody's and Fitch have both recently warned they might also downgrade the U.S. government's blue-chip rating, if the country doesn’t address its rising debt by early 2013.

Since March 1962, debt ceiling increases have been enacted 76 times, according to the Congressional Research Service. Congress has voted to raise the ceiling 11 of those times since 2001.

So why does Congress even bother to set a debt limit?

“We are one of the only nations in the world with a debt ceiling limit,” said Robert Johnson, finance professor at Creighton University.

“The necessity of voting to raise the debt ceiling periodically acts as somewhat of a check on unfettered debt,” Johnson said. “I’m not in the camp that favors eliminating the debt ceiling as I think it serves that useful purpose.”

Obama abandoned his demand for permanent borrowing authority. Instead, he is now asking for a new debt limit that would last two years, putting its renewal beyond the politics of a 2014 midterm election. House Speaker John Boehner, R-Ill., is pushing for one.

“If little progress is made and the level of acrimony remains high prior to the 2014 midterm elections, incumbents from both parties will suffer,” Johnson said.

Moderate Economic Growth In 2013

For 2013 as a whole, economists polled by Reuters expect the U.S. economy to expand by a modest 2 percent, much the same as this year.

Any deal [to avoid the fiscal cliff] will incorporate some degree of fiscal tightening next year. At the bare minimum, tax deductions for higher income earners will be reduced and non-defense discretionary spending will fall, Paul Ashworth, chief U.S. economist at Capital Economics, wrote recently.

Harris, of Bank of America Merrill Lynch, is less optimistic. “We expect a double whammy of uncertainty and austerity will push growth to just 1 percent in this quarter and next. For 2013 as a whole we expect just 1.5 percent GDP growth,” Harris said.

Recent consumer confidence data have provided some evidence that high-income earners are becoming more pessimistic.

According to the Conference Board, the confidence of households earning over $50,000 a year fell in November. This is hardly conclusive. But as the tax cuts for high-income earners are the least likely to be renewed in any deal to avoid the fiscal cliff, it makes sense that high-income earners are becoming more downbeat.

Taxes on one-percenters would rise an average of $121,000, according to the nonpartisan Tax Policy Center.

Capital gains. This year, investors pay a top marginal tax rate on their long-term capital gains of 15 percent. Under current law, this rate will jump to 20 percent in 2013, not including the additional 3.8 percent increase from the Affordable Care Act on high-income investors. In addition, a limitation on itemized deductions is also scheduled to kick in at the end of this year that could add another 1.2 percent.

Investors worried about paying higher capital gains taxes next year are rushing to sell off by year's end.

“We are seeing a lot of our clients, whether they are buyers or sellers, trying to close their deal within this tax year,” said Deborah DiVerdi Carlson, a partner at Boston-based law firm Posternak Blankstein & Lund. “If they are sellers, they are hoping to enjoy the lower capital gains rate that will still apply in 2012. If they are buyers, they are getting pressure from the other side to close the deal.”

Dividend income. A steep tax hike to 43.4 percent from 15 percent on dividend payments could come into effect next year. As a result, more than 420 special dividends have been announced just in November and December, which will soon exceed the 433 paid in all of 2011, according to S&P Capital IQ.

Some companies have also moved their planned dividend into late December from early January to help soften the blow for shareholders. Wal-Mart Stores, Inc. (NYSE: WMT) announced that its fourth-quarter dividend payout, originally scheduled for Jan. 2, will be paid on Dec. 27, and Costco Wholesale Corp. (Nasdaq: COST) and Oracle Corp. (NASDAQ:ORCL) also moved up their first 2013 dividend payments.

Although Democrats and Republicans could still hammer out a deal that won’t raise the taxes on dividends quite as much, corporate America is not taking chances. “Our clients are contacting us and they want to take action on the expectation that there won’t be any legislative compromise,” Carlson said.

There has been substantial healing in the private sector since the 2008-09 crisis, and the housing healing is particularly encouraging.

“Once the cliff is resolved, the economy will return to its moderate recovery,” Harris said. “In other words, the 50 states are fine; the District of Columbia is the problem.”

“They need to put a deal together that raises revenue while maintaining adequate demand so the economy continues to heal and generates confidence that we have the discipline to adhere to the plan,” said Joseph M. Giglio, a professor of strategic management at Northeastern University's College of Business Administration.

Winston Churchill famously said, “You can always count on Americans to do the right thing -- after they have tried everything else.” Well, let’s hope so.