Tuesday, October 15, 2013

Uneasy lies the head.

At the end of 2012, after he had been safely ensconced in the White House for another four years, President Obama had a chance to put all of the budget wrangling to bed, for good. The Bush-era tax cuts--passed as the Republican solution to the accumulating surpluses beginning in the last years of the Clinton presidency--were set to expire at the end of 2012, and the President had a choice to make. He could make a budget deal with Congress to extend some or all of the tax cuts, or he could do nothing.

For a decade, it had been a Democrat mantra that the Bush tax cuts were the cause of our fiscal imbalances, and that they should be repealed at best, or allowed to expire, at worst. As President, Barack Obama had repeatedly talked about the need for more revenue. But, at the end of the day, even with his reelection behind him, he was not prepared to seize the moment. He was not prepared to allow tax rates to go up on the middle class, even if only to the levels in place at the end of the Clinton presidency. Thus, the moment was lost and the surge in federal debt continued.

Today, such a moment has been reached for Senator Ted Cruz. Newly arrived in the Senate, Cruz emerged as the majordomo of the House Tea Party Republicans who have chosen to use their leverage over the funding of the government and raising of the debt ceiling to win concessions on spending and the implementation of the Affordable Care Act. Like President Obama, Ted Cruz has the opportunity of a lifetime to change the course of American history, simply by convincing his minions in the House of Representatives to do nothing. Just as by doing nothing late last year, President Obama had the opportunity to resolve decades of partisan wrangling over deficits, so too Ted Cruz can achieve the equivalent of the Tea Party holy grail of a balanced budget amendment to the Constitution if he has the nerve to stand his ground.

In the last iteration of the debt ceiling negotiations, in 2011, the resolution included the requirement that there be a Congressional vote on a balanced budget to the Constitution. Of course, such a vote required a two-thirds majority prior to even being considered by the states, and, as such, was a non-starter. But a balanced budget amendment remains the sine qua non of the libertarian and Tea Party world views, and now Ted Cruz has it within his grasp.

Ted Cruz may have felt heat before, somewhere in his life, but it is nothing like the pressure he will come under in the next 48 hours. For almost a week now, John Boehner and the House suicide caucus have faded from the front pages, and Cruz himself has been the target of unrelenting ire within the Republican establishment. DC elders, having failed to make progress in the House, turned to their attention to putting together a deal in the Senate, in the hope that at the last minute, faced with the fate of the world hanging in the balance, Ted Cruz and the radicals in the House would fold.

Karl Marx famously observed that historical personages and events appear twice, the first time as tragedy and the second time as farce. And thus it appears to be with these debt ceiling events, as this one has devolved into one more media extravaganza. Two years ago, world markets took the notion of an American default quite seriously. The Dow dropped over 16% as that prolonged negotiation dragged on, and bond market volatility was pronounced. Not so this time. With 48 hours to go before the apocalypse descends upon us--with dire predictions of rising Treasury bond yields and plummeting stocks--markets remain largely unaffected. The Dow is down less than 1% over the past month, and benchmark Treasury bond yields are lower now than one month ago. Investors, it seems, no longer take Washington predictions of doom too seriously.

There are two pivotal insights here. First, the bond markets appear to have internalized the simple truth that there will be no payment default on any U.S. Treasury obligations, come what may. When any Treasury securities come due--obligations that bear the full faith and credit of the United States of America--and are presented to the Federal Reserve Bank for payment--the same Federal Reserve that creates $85 billion each month out of whole cloth in its quantitative easing program--they will be paid. There are no effective constraints to such payments by the Fed, and to not pay maturing Treasury securities when due would violate the 14th Amendment to the Constitution.  

Second, from a bond market perspective--and given the fallacy of the potential for a payment default--all of the institutional pressures from the fiscal negotiations point to downward pressures on deficits, one way or the other. Therefore, the future looms to be one of reduced borrowing, reduced debt, and, the ravings of the anti-fed faction in the Cruz caucus notwithstanding, low inflation. All of those factors translate into lower bond interest rates, not higher ones. For now, with the global depression continuing to haunt Europe and Japan, or the Chinese yuan as little more than a proto-currency, investors have nowhere to go but the dollar.

Goldman Sachs has estimated that a failure to raise the debt ceiling would cause a 4.2% pullback in economic activity, thus the real consequence of a failure to raise the debt ceiling will be to throw the U.S. economy into recession. Goldman's report suggests that this, rather than any cash default, would be the material consequence of non-action by Congress.

This is the endgame that Ted Cruz is playing with. It is the path of least resistance to achieve the effective equivalent of a balanced budget amendment. But unlike the passage of a balanced budget amendment, there would be no phase in or time to prepare. Instead, if funding is curtailed effective this Friday morning, the impact will be harsh and it will be immediate.

The media consensus is that the Republican Party is the loser as a result of the ill-conceived strategy thrust upon them by Ted Cruz, and that Republicans must ultimately come crawling back to the President and the Democrats, take their medicine, and forsake their goals. But Ted Cruz does not have to play it that way. His is a high stakes game for the nation, as well as for Cruz himself. If he folds his cards now, just as victory lies within his grasp, the Tea Party movement will have been stripped bare and left with nothing but the continuing antics and buffoonery of their clown princess Sarah Palin, with Cruz relegated to the shadows. Instead of the resentments of his peers in the Senate, it will be the Tea Party base that will turn on Cruz for his weakness, and thus dash his own political ambitions.

But if Cruz confounds the odds and plays his ace card, he will cast the nation into an uncharted economic abyss. There is a reason that balanced budgets have not been achieved through the normal appropriation process: everyone, on both sides of the aisle, likes to spend money and bring home the bacon for their constituents. Members of Congress may like the Ryan budget in theory--for all his rhetoric, Ryan never specifies what he would cut to bring spending down to 19-20% of GDP--but in practice no one wants to cut anything that benefits their constituents or their contributors.

That is the outcome that could transform the nation, and its budget debates, as Cruz's most loyal Tea Party acolytes would learn the hard way that their Medicare and veterans benefits, and the other programs upon which they rely, are all the stuff of government. With tax receipts only covering 81% of mandatory and discretionary spending, everything would be cut back significantly. Ted Cruz will have delivered the holy grail to his followers, but in the face of the turmoil that ensues, he may find little he garners little gratitude or praise in its wake.