As the possibility of a bigger deficit-cutting deal fades away, the status quo will be upheld -- and nobody should be surprised
The congressional "supercommittee" is looking pretty lame. Its failure approaches as the group of twelve Republicans and Democrats tasked with reducing the deficit can't come to an agreement. The divide that they cannot overcome stems from mostly what you would expect: the right wants bigger spending and entitlement cuts, while the left wants to raise taxes. Neither side will budge, so the so-called "trigger" will be pulled instead, which will automatically cut $1.2 trillion from the federal budget over the next 10 years. Will the market react with a nod, a frown, or a shrug?
The Market Shouldn't Be Surprised
In fact, the market should be unfazed: it should have expected precisely this outcome. The supercommittee was essentially designed to fail. What we have come to know about Congress is that it waits until the absolute last second to act when it absolutely must. In this case, however, it wasn't under any real pressure to act. Even its failure to compromise would result in an action that neither party liked, but each would likely see as better than making political concessions.
Think about the political ramifications of an agreement being reached. For that to occur, either Republicans or Democrats (or both) would need to compromise their principles. And for what? Even if they don't agree to a compromise, cuts will happen anyway. As you may recall, even when the nation was on the verge of a default due to hitting the debt limit in August, Congress barely managed to avoid catastrophe. Can anyone reasonably expect a broad, aggressive compromise when politicians are under so little pressure?
The Status Quo Upheld
By now, the market should understand this. It should have priced in a supercomittee failure. But from the market's perspective, that failure might not look all that different from success: either way, little more than $1.2 trillion in deficit cuts would have occurred. Even if a compromise was reached, almost no one expected cuts to much exceed $1.5 trillion. So success and failure should have looked approximately the same from the market's standpoint anyway.
On some level, the market might even be relieved. After all, Congress could have done something stupid instead. If the supercommitte had felt really aggressive about deficit reduction, it could have cut too deeply too quickly and endangered the already weak economy. Slicing a mere $1.2 trillion off of the budget over 10 years starting in 2013 isn't likely to reverse whatever modest recovery might be taking place in the U.S.
And really, at this time, the market doesn't appear to be calling for anything much more aggressive. Treasury yields remain ridiculously low. At the end of last week, 10-year Treasury yields dipped below 2%. At this time last year, they were near 3%. A decade ago, they were around 5%. Despite the U.S.'s unsustainable debt path, investors remain very, very comfortable with Treasuries. Can you really blame them? Compared to Europe, the U.S. looks like a pretty great place to park your money.
What Could Upset the Market
Of course, Congress could still screw things up. Some politicians have been threatening to reverse some of the $1.2 trillion in cuts. After all, if Congress agrees to cut less, then it can -- no law is immutable. While this might not have any tangible short-term consequences, it could worry some investors. If Congress can't even allow this very modest amount of spending cuts that result in relatively similar pain for both parties, then how can the deficit ever be cut more aggressively?
What the market probably thinks, rightly or not, is that eventually Congress will get its act together. Frankly, now isn't the time for austerity. Demand for U.S. debt is extremely strong. The U.S. economy remains fragile, with employment improving only mildly as far too many Americans remain jobless. While the market doesn't view immediate spending cuts or tax hikes as necessary, the path of U.S. debt is clearly unsustainable. At some point, a longer-term, more aggressive deficit reduction plan must be put in place. If the trigger disintegrates, then this could be a sobering signal about the dysfunctional nature of Congress.
That would certainly worry the rating agencies too. If the trigger is reversed, then Moody's and Fitch might have to think more seriously about joining S&P in downgrading U.S. debt. This action would demonstrate a pretty clear unwillingness on the part of Congress to take even slight measures to reduce deficits.
Assuming that the trigger is pulled, the only sticking point that could concern the market has to do with short-term tax policy. Without a new agreement in place, a payroll tax cut extension and a patch for the alternative minimum tax may both fail to materialize. If Congress doesn't take action in December, then taxes will rise for some Americans, which the market may worry could have a negative impact on the U.S. recovery.
As far as broader deficit reduction implications are concerned, we'll have to see how the political terrain looks in 2013. If the trigger remains intact, then the market should expect Congress to take little additional action on the deficit until then. During a presidential election year, few in Congress will be willing to take a stand or compromise.
What happens in 2013 hinges on the 2012 election results. If one party sweeps next November, then the flavor of deficit cutting should be pretty clear. If President Obama wins a second term, Democrats take back the House and increase their majority in the Senate, then taxes will rise. If Republicans take the Senate and win the White House, then we will likely see more aggressive entitlement reform and deeper budget cuts. As long as gridlock remains in place, however, little deficit reduction will occur.
Image Credit: REUTERS/Mike Theiler