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Debt Ceiling: Will the US Follow Minnesota's Lead?

Jonathan S. Henes|Partner, Kirkland HKSCKPVIamp; Ellis LLP
Wednesday, 6 Jul 2011 | 11:26 AM ET

The markets seem to believe that the federal government will raise the debt ceiling before August 2. And the markets may be right.

Uncle Sam taking money out of your wallet
iStockphoto
Uncle Sam taking money out of your wallet

In the absence of raising the debt ceiling, the U.S. will be forced to decide whether to pay interest on its bonds to avoid a default (which it would choose) or ordinary expenses, such as social security, medicare and military personnel salaries.

Avoiding these tough and, potentially, debilitating choices may cause the Democrats or Republicans to blink.

However, the shutdown of Minnesota's government demonstrates that politicians do not always blink, and the consequences from their failure to compromise can be great.

If the federal debt ceiling debate ends up like the budget showdown in Minnesota, the Treasury will need to determine which 40 percent of the federal government's obligations to cut immediately, and the market and public reaction may be swift and severe.

So what happened in Minnesota?

Minnesota has a $5 billion budget deficit. Governor Mark Dayton, a Democrat, led negotiations with the Republican leadership regarding how to close the gap. During the negotiations, it was a given that education and social services would be cut dramatically. They needed to be to balance the budget.

The primary disagreement between Gov. Dayton and the Republican leaders was about the Dayton's proposal to increase taxes on Minnesota's 7,700 millionaires. The tax proposal was being floated as a counter-balance to the significant spending cuts to education and social services.

The negotiations died over this issue, and Minnesota was unable to pass its budget by midnight on June 30, the end of its fiscal year. Consequently, Minnesota has been unable to meet its obligations and parks and toll roads have shut down, which may lead to larger problems for Minnesota as the state is losing millions in revenue.

With the state shut down and the background of angry taxpayers, Dayton has indicated his willingness to re-start negotiations in an attempt to close the budget deficit and re-open the government. If the government does not re-open shortly, then the state will exacerbate its fiscal woes, leading to a more complex situation next year.

Are the debt ceiling negotiations different than the Minnesota budget negotiations?

Yes and no. The magnitude of the situation clearly is different as certain politicians, administration officials and economists have predicted a calamity if the U.S. defaults on its bonds. However, the United States will not default on its bonds.

Nonetheless, if the debt ceiling is not raised, the U.S. will need to pick and choose which obligations to satisfy.

President Obama made this clear last week when he said, “So are we really going to start paying interest to Chinese who hold Treasurys, and we're not going to pay folks their Social Security checks?”

Like Minnesota, the major sticking point between Democrats and Republicans is taxes.

In the President's words, "Any agreement to reduce our deficit is going to require tough decisions and balanced solutions. And before we ask our seniors to pay more for health care, before we cut our children’s education, before we sacrifice our commitment to the research and innovation that will help create more jobs in the economy, I think it’s only fair to ask an oil company or a corporate jet owner that has done so well to give up a tax break that no other business enjoys."

The Republicans are pressing for major spending cuts and caps, as well as a clear path forward to a balanced budget and are strenuously resisting tax increases in any form.

U.S. House Speaker Boehner, clarifying his resistance to any tax increases, said that "the President and his party may want a debt limit increase that includes tax hikes, but such a proposal cannot pass the House."

So, will the debt ceiling get raised?

This is the $14.3 trillion question. And the answer is clearly up in the air. It is also clear that many politicians, both Democrats and Republicans want a deal on the debt ceiling.

For instance, U.S. Sen. Cornyn said the Republicans would accept a mini-deal with the administration to raise the debt ceiling, thereby kicking the federal debt bomb down the road for a while.

But, will the Tea Party Republicans in the House back down and agree to the raising of the debt ceiling without long-term and substantial spending cuts and caps? What about the administration? The Wall Street Journal reported today that President Obama has rejected a temporary fix.

What happens if the debt ceiling doesn't get raised?

This is up for debate. Some believe that the markets will hardly react because the debate itself demonstrates that the U.S. will address its long term issues, even if it doesn’t do it right now.

Others believe that the economy will collapse, the markets will fall into chaos and interest rates will rise precipitously. While we don’t know who is right, we do know that the administration will need to make tough decisions about who to pay and who to stiff. The Bipartisan Policy Center conducted a studyon what would occur if the debt ceiling is not raised.

The following findings are notable:

  • The Treasury has never failed to meet any payment obligation during a debt limit debate.
  • If the Treasury needs to prioritize payments, unfair results will occur and there could be public uproar.
  • The federal government’s August receipts will be approximately $203,327,000 and its obligations will be $306,713,000, thus creating a shortfall of $134,312,000.

Specifically, some of the federal government’s obligations are:

  • Interest on Treasury Securities: $29 billion
  • Social Security Benefits: $49.2 billion
  • Medicare/Medicaid: $50 billion
  • Defense Vendor Payments: $31.7 billion
  • Unemployment Insurance Benefits: $12.8 billion
  • IRS Refunds: $2.9 billion
  • Military Active Duty Pay: $2.9 billion

All of this results in an immediate 44 percent cut in federal spending.

Are we watching the same movie?

It is not outside the realm of possibility that the debt ceiling will not get raised, the government will fail to meet certain current obligations, protests will erupt, interest rates will rise and the economy will take a severe hit.

If this occurs, we may see Congress rush back to the negotiating table to reach a deal that will raise the debt ceiling and stop the bleeding. However, whether a calamity occurs or the issues are delayed for another day, our leaders need to put their rhetoric aside and focus on the massive debt problem we face as a nation.

They need to realize that on the federal level our addiction to debt may cause us to overdose and at the state and local level the budget deficits and unfunded pension liabilities may destroy our education system and our ability to compete in the world.

It's time to get serious on a non-partisan basis and come up with a long-term, comprehensive restructuring plan. We have plans on the table, such as the Simpson-Bowles deficit commission plan and Bill Clinton’s corporate tax rate proposal, and now it's time to determine the path forward and execute.

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Jon Henes is a partner in the restructuring group at Kirkland & Ellis LLP where he has led some of the most complex restructurings in the United States and abroad across a variety of industries, including media, chemicals, energy, manufacturing, real estate, retail and telecommunications. Jon has also frequently appeared on CNBC's "Worldwide Exchange" as a guest expert on various financial and economic topics, federal, state and local fiscal issues.

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