Prospects for a Deal
Obama gave a speech on Friday to reassure markets and urge bipartisanship. The tone of the speech was essentially upbeat and highlighted several avenues for compromise.
Separately, reports circulated on Friday that the House may pass John Boehner's proposed plan if a provision is inserted that requires passage of a Balanced Budget Amendment before the debt ceiling is reached again.
The market rallied intra-day on Friday morning on these items. The reason for such optimism is not immediately apparent.
Clearly, a balanced budget amendment provision widens the gulf between the parties. If the House bill was “dead on arrival” in the Senate, the balanced budge provision simply defiles the corpse.
The optimism of the market can only be understood in the following context: Passage of a bill -- any bill -- will kick off a new stage in the negotiations whereby House and Senate leaders will begin the conferencing process to come up with a compromise bill that both the House and Senate can pass. And indeed, history suggests that once in conference, leaders will be able to broker plan that can get enough votes. More so with the gun of default held to their collective heads.
The scenario for a compromise bill is that Boehner agrees to water down the House plan by jettisoning the balanced budget amendment requirement and making a few concessions to bring the joint bill a bit closer to the Harry Reid-sponsored Senate plan that will likely pass Friday afternoon. The compromise plan that will come out of the House-Senate conference will lose the support of some hardcore Tea Party Republicans in the House, but that will be compensated by the Democratic leadership getting House Democrats to make up the difference. I see few scenarios in which Senate passage will become an impediment. Indeed, I can see a scenario of a compromise bill passing by a wide margin in both chambers of Congress.
Note that under this compromise scenario, Congress will have to approve another increase in the debt limit within six to 12 months. However, immediate default will be averted.
Relief that default may be averted explains the rally Friday morning. Furthermore, the specter is being raised for a relief rally early next week if Congress averts default and a bill is passed, particularly if it is accomplished by a wide margin.
Ominous Clouds Gathering Ahead
Notwithstanding the relief that will be caused by averting default in the short term, I will reiterate what I said yesterday in my article What Would a "Good" Deal on the Debt Ceiling Look Like?: Any deal that does not take the debt ceiling out of play for 18 months is going to be bad for the economy and for the market. I do not believe that the economy or markets can make any headway in the face of continual bickering, grandstanding, and imminent threat of default
Unfortunately, as described in the fist section of this article, the probabilities of getting a "bad" deal are more than 50% and rising. Indeed, last night’s and this morning’s developments have greatly increased those probabilities.
Another factor needs to be accounted for. Given the time constraints, the probabilities of no deal by the August 2 deadline are rising significantly. While this does not imply default, it raises the specter of the government delaying and/or withholding payments to suppliers, entitlement holders, and etc. Talk about reverse fiscal stimulus! Thus, while the probability of this fiscal retrenchment scenario is probably still below 50%, the probabilities are rising extremely fast. And this is a development which — if it drags on for more than a week or so -- could break the back of the feeble economic expansion.
