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Craig Allen: Forget the Fiscal Cliff, What about the Debt Ceiling — Again?

Despite the impending doom of the fiscal cliff (and we can’t really forget about it), there is a potentially more serious problem Congress and President Barack Obama will be forced to address by February, if not before: the debt ceiling. If the previous debates and the resulting gridlock and government shutdown that we experienced are any indication of what we can expect, wrangling over raising the debt ceiling again promises to be contentious.

Over the past few months, market pundits, economists and financial writers (including myself) have been prognosticating on the perils we face as a nation, and the dire implications for securities markets and our economy, when we reach the end of 2012 and face the “fiscal cliff” — the expiration of the Bush-era tax cuts and significant spending cuts that will go into effect as a result of the previous debate on the debt ceiling.  The big concern is that Congress and Obama will have a difficult time agreeing on any plan to extend those Bush tax cuts or postpone the spending cuts.

Obama and fellow Democrats are dead-set against any cuts to entitlements — spending on Medicare, Social Security and other benefit programs. These government expenditures account for almost two-thirds of total government spending, are automatic (meaning they don’t require a specific vote by Congress and a signing of a bill into law by the president), and are the fastest-growing part of the annual budget. Discretionary spending, which encompasses federal agency budgets for everything from the military and national parks to food safety inspections and weather forecasts, is the area that typically suffers cuts whenever the government has budget challenges and must cut back.

Discretionary spending has been the focus of previous budget deals and, according to the nonpartisan Congressional Budget Office, is moving toward falling below 6 percent of the size of the economy by 2022, which would be the lowest level in at least 50 years. Any agreement that relies heavily on deep discretionary cuts risks a reliance on savings that future lawmakers could find unbearable and would simply rescind, negating any meaningful positive impact on the budget deficit or our national debt. Democrats seem unwilling to even discuss slowing the planned spending rate increases scheduled for entitlements, much less actual cuts to entitlement spending.

Republicans seem dead-set against any increases in tax rates, especially the top tax bracket of 35 percent (Obama and the Democrats want to raise this rate back to 39.6 percent for income earners at and above the $200,000 level for individuals and $250,000 for couples and families), although House Speaker John Boehner, R-Ohio, the Republicans’ top bargainer, has indicated some willingness to negotiate on tax increases.

In an environment like this, with such a contentious relationship that exists between Obama and the Democrats on one side, and the Republicans on the other, and with such a deep chasm separating these two sides from any common ground, the fiscal cliff may seem like more than enough to give investors pause. But we also face running into the debt ceiling once again, which will require another agreement between Congress and Obama. If the last debt ceiling debate is any indication, we are in for a potentially more contentious fight than we face with the fiscal cliff.

In 2011, when the United States neared the previous debt ceiling — the maximum level of national debt allowed by Congress — Congress and Obama crossed swords over the terms of the agreement to raise the amount the government could borrow. The government actually shut down (ran out of money and couldn’t pay its bills, before an agreement was finally reached. After the legislation was passed by both the House of Representatives and the Senate, Obama signed the Budget Control Act of 2011 into law on Aug. 2, 2011. Four days later, on Aug. 5, Standard & Poor’s downgraded the U.S. sovereign credit rating for the first time in the country’s history. Markets around the world as well as the three major indexes in the United States experienced their most volatile week since the 2008 financial crisis with the Dow Jones Industrial Average plunging 635 points (or 5.6 percent) in one day.

As part of this agreement, deep spending cuts were set to go into effect on Jan. 1, 2013 — the very same spending cuts that we are facing now as part of the fiscal cliff. With these impending spending cuts already threatening, along with the Bush tax cuts expiring, Congress must go back to the drawing board to debate yet another debt ceiling increase in order to derail the anemic economic growth we’ve experienced since the latest recession.

The national debt is just under $16.3 trillion. The current debt ceiling (limit) is $16.4 trillion, which we could hit as early as next month. While the government can finagle some of its spending and financing to extend the time before the debt ceiling must be raised by a few months, by February at the latest, Congress will be forced to raise the debt ceiling, or once again face running out of money and shutting down.

A shutdown would very likely have an even more pronounced, negative impact on financial markets than was experienced in 2011 after the last debt-ceiling debacle. While a quick-fix solution (Band-Aid) to the fiscal cliff is possible before the end of this year, any real, permanent and meaningful solution that will effectively address the runaway budget deficits and national debt growth will need to include an agreement on the debt ceiling.

There can be no doubt that we must stop increasing spending on entitlements and discretionary items, and we must raise taxes. We also must raise the debt ceiling because there is no way to cut spending and increase revenues in the next two or three months by enough to avoid it. While we can hope that politicians on both sides recognize the importance of coming to an agreement that effects real improvement in the budget deficit and national debt, politicians rarely act in the best interest of the country as a whole, voting instead in the best interests of their specific constituencies (or more to the point, those that contribute the most to their re-election campaigns).

I have little faith in the ability of Congress and Obama to agree on anything that will get the job done. If anything, the outcome of the most recent elections has emboldened the Democrats and embittered the Republicans to align with the most extreme elements of their respective parties. We have just five weeks remaining in 2012 — just five weeks for Congress and Obama to find common ground and save us all from the severe economic consequences we face if the fiscal cliff and debt ceiling are not dealt with effectively. I have little confidence that an agreement will be reached. In light of this view, the recent bounce in the stock market appears to me to be wishful thinking and ill-advised.

Craig Allen, CFA, CFP, CIMA, is president of Montecito Private Asset Management LLC and founder of Dump Your Debt. He has been managing assets for foundations, corporations and high-net worth individuals for more than 20 years and is a Chartered Financial Analyst (CFA charter holder), a Certified Financial Planner (CFP) and holds the Certified Investment Management Analyst (CIMA) certification. He blogs at Finance With Craig Allen and can be contacted at .(JavaScript must be enabled to view this email address) or 805.898.1400. Click here for previous Craig Allen columns. Follow Craig on Twitter: @MPAMCraig.

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