Thoughts on the Debt Ceiling

It seems clear to me that there are two big bluffs happening in this debate. 

Republicans say that the only way they will allow the debt ceiling to rise is if there are significant spending cuts.  However, while the Tea Party might be calling the shots politically for the Republicans – Wall Street is still paying the bills.  The Tea Party might think that default is acceptable but Wall Street knows better and so does the majority of the Republican party.  There is no way that Republicans will fail to pass some kind of a deal.

Obama says that he will veto any compromise that simply kicks the can down the road a few more months.  Right now public opinion is putting the failure to find a compromise in the hands of the Republicans.  If there is simply no deal – Republicans will take a heaping portion of the blame and they know it.  However, if a deal passes the House and the Senate and Obama vetoes it – then he has just taken sole responsibility for the ensuing mess.  There is no way Obama vetoes any reasonable deal that comes across his desk.

The most likely outcome is something along the likes of the McConnell plan – a (more or less) clean vote in which Obama takes responsibility for raising the debt ceiling and the Republicans can claim that they voted against it.  Whether that happens right before or right after August 2nd is anyone’s guess.

So how will the stock market react?

The United States is facing two undesirable choices: 1) Take on more debt and risk the long-term solvency of the country or 2) Accept harsh austerity in the short-term and risk plunging the country right back into a recession.

While the stock market is a discounter of probable future events, the time horizon is usually only a couple months.  Politically most of Wall Street seems to believe the theory that the ongoing economic weakness is caused by a lack of confidence due to excessive government spending.  Therefore, one might think that the stock market would rally on the news of a “Big Deal” that makes severe cuts to government spending.  However, I suspect that the opposite would happen – austerity in America would cause the stock market to sell-off as investors price-in what would likely be a huge economic hit.  Such a reaction would be a true test of political beliefs versus economic realities.

However, the McConnell plan simply kicks the can down the road – which would mean that the next few months would likely look a lot like the last few months: not a lot of jobs but a lot of corporate profits.  I suspect that the market would rally on the McConnell plan – again proving that economics trumps politics when it comes to investing.

Some additional thoughts:

• The time to debate spending cuts is when the budget is being set.  Debating on spending cuts when the bill comes due is incredibly irresponsible.  Imagine going to a restaurant and ordering a meal, then deciding that you can’t afford it once the check comes.
• Voters are generally in favor of cutting government spending conceptually.  However, voters tend to be opposed to specific cuts in government spending.  So far the proposed cuts have been all general numbers with no specifics attached – and the anxiety of getting a deal done is taking precedence over the details.  But wait, just wait, until the specific cuts are announced and people are protesting in the streets.