The Debt Ceiling Deal: Long-Term Questions Remain
August 3, 2011

In what may have been the biggest nail-biter in recent legislative memory, a divided U.S. Congress finally ended a bitter stalemate on increasing the U.S. debt limit on Tuesday. The compromise reached between Republican and Democratic lawmakers enables the U.S. to raise its debt ceiling conditioned upon up to $2.4 trillion in spending cuts over the next 10 years. In so doing, America has avoided a possible default and its potentially dangerous economic consequences.

Michael Hasenstab

Michael Hasenstab

Dr. Michael Hasenstab, Co-Director of the Franklin Templeton Fixed Income Group and Portfolio Manager of the Templeton Global Bond Fund thinks that while the plan avoids default in the near term, it doesn’t go far enough in addressing the nation’s long-term debt problem.  In his words,

 “In some sense, yes, we avoided the worst-case scenario, which would have been a missed payment or a default. However, I don’t think the solution—or what was passed —really addresses the issue of the long-term finances of this country.” 

In particular, Hasenstab believes significant entitlement reform is needed to curtail America’s long-term debt trajectory. Although the deal cuts more than $2 trillion over a decade, the yearly deficit alone is about a trillion dollars. And if the economy slows further, that deficit may even grow, especially if tax receipts decrease or additional stimulus spending is implemented. This concerns Hasenstab, because despite the cuts, the deal’s inability to cope with the larger, structural debt issue may still give credit rating agencies a reason to downgrade the U.S.

“… I think a potential downgrade certainly is in the cards. They [credit rating agencies] had asked for serious entitlement reform, and we didn’t get that – we got a little bit, but not really a lot.”

Roger Bayston

Roger Bayston

Roger Bayston, Director of Fixed Income for the Franklin Templeton Fixed Income Group and Portfolio Manager of the FranklinTotal Return Fund, thinks while the U.S. AAA credit rating is likely still valid, in the longer-term, issues may arise:

 In our assessment, the U.S.’s debt servicing ability as a percentage of tax revenues currently reaffirms the country’s AAA rating. However, if we look out several years, say to 2015, that ratio potentially becomes much less supportive of the top credit rating, and we believe that the longer-term picture is what has been driving the credit ratings agencies to review the U.S. sovereign credit rating. For the ratings agencies, this latest controversy about raising the debt ceiling appears to have been less about the near-term issues—how does the federal government continue to function and finance itself—and more about the long-term challenges, namely the mismatch between expenditures…and the revenue needed to back those obligations.”

Congress’ agreement includes a first tranche of approximately $900 billion in cuts from discretionary spending (including some from entitlement programs), with an additional $1.2 to $1.5 trillion in some combination of cuts and increased revenue that are dependent upon a special bipartisan joint committee’s recommendations. The committee needs to agree upon at least $1.2 trillion by November 23; if it cannot reach an agreement, a backup provision will automatically cut the $1.2 trillion from a combination of defense and discretionary programs. This back-up plan is designed to serve as a motivator for compromise to committee members, since many Republicans shiver at the thought of large defense cuts, while Democrats typically cringe at the thought of massive entitlement cuts.

Still, Hasenstab cautions that it’s not just cutting for cutting’s sake. Ill-timed cuts or those which do not address larger, structural issues, such as entitlement reform, may not deal effectively with the debt:

 ”Certainly, you want to be careful [with] how you manage your expenditures in a period when the economy is weak – you want to stage that out. But I think what the markets were really looking for was not necessarily a $2 trillion cut in government spending today, but really addressing the longer-term entitlement issues…it’s not saying you have to cut all that spending in year one, but just have a tangible plan that has hard components that politicians have to hold to.”

While the debate over the debt ceiling has been dominating airwaves, negative economic news has still been filtering through, contributing to a U.S. sell-off in equities Tuesday and growing pessimism over the recovery. However, Hasenstab seems less concerned about the possibility of a “double-dip” recession, in part due to the strength of the U.S. corporate sector:

 “Well, you’re still growing, but there will be a period where it looks like it might be turning, but it’s just a temporary soft patch. And I think that’s very common, but especially in this recovery where there’s a lot of deleveraging that has to work through the system, it’s not surprising…but the global economy still seems fairly robust. The U.S. corporate sector is still incredibly strong and robust, and while the labor market hasn’t rebounded as we would like to have seen, it’s somewhat offset by the strength in the corporate sector. So, I think it’s possible for the U.S. recovery to continue and the market negativity on that is a little exaggerated and overstated.”

 

So, while all may not yet be rosy on the economic front, the picture isn’t entirely one of doom and gloom. And in dealing with the debt or at least part of it the U.S. has likely taken another step toward recovery.

If you’d like to watch the entirety of the interview with Dr. Hasenstab, please click here.

Until next week, Beyond Bulls & Bears leaves you with a quote from the late Sir John Templeton,

 The only certainty about the future is that it will be different from the past.”


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