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Eye on the Market | July 25, 2011
J.P.Morgan

Topics: US debt ceiling negotiations, a more ambitious European bailout plan (finally), and how large cap growth stocks and rising corporate profits are patiently waiting for both of them to end

White Castle. Twenty five years ago, I had a friend with a peculiar way of responding to seeing things he didn't like on TV: he would throw White Castle hamburgers at the screen. I always thought this was a bad way to waste a good hamburger, but I had one of those moments the other night when watching news reports on debt ceiling discussions. Media outlets have referred to President Reagan's scolding of Congressional Republicans for delaying debt ceiling increases, and the 18 increases that took place during his Presidency. The implication: reservations about raising the debt ceiling are as irresponsible now as they were then. This is a disingenuous argument; in the 1980's, the debt ceiling being debated was 50% of GDP, and had no bearing on the solvency of the United States. Today, the proposed increase raises the debt limit twice as high, measured relative to GDP or government revenues. While a default is a very bad idea (deserving of a White Castle hurling of its own), unconstrained debt growth with no plan to slow it is bad as well. Some suggest we not worry about debt growth, since demand from foreign central banks and the Federal Reserve would keep yields in check. That logic is irresponsible at best. Debt limit legislation is a rocky but healthy way for a democracy to decide whether mega-deficits are in the long-term public interest.

Debt limit debate of the 80's: an entirely different discussion
Percent Multiple
[Chart showing Debt limit to GDP vs Debt limit to gov. receipts from 1950 to 2010]
Reagan scolds Congressional Republicans for not raising the debt ceiling
Source: OMB, BEA, J.P. Morgan Private Bank.

Over the last few days, the Gang of Six plan, the Reid-McConnell plan and the Obama-Boehner plan have all been raised up the flagpole and then lowered. By the end of the process, we're still looking for deficit reduction of $3 trillion+ over 10 years (relative to the CBO Alternative case in which there is no deficit reduction at all). However, Congress is running short on time, and may have to do a smaller debt ceiling increase/deficit reduction first. For now, we wait to see the balance of spending cuts and revenue increases¹ will be agreed to. Last week's Profiles in Courage piece walked through the history and dynamics of this process, so we won't repeat that here. Here's our take on what has been proposed so far, with the caveat that many plans are not crystal clear what baseline they are using², or what steps they recommend to get to that baseline first.

What's on the menu? US long-term debt scenarios
Net debt to GDP, percent
[Chart showing debt projections 2010-2021]
Reid-McConnell, Phase I
CBO Alternative Case
CBO Baseline
Reid Plan Pres. Budget Boehner 1 Plan
Gang of Six

[Chart Legend/Text Explanations]
All tax cuts extended; AMT indexed to inflation; no Medicare reimbursement cuts
Cuts to discretionary and entitlement spending
Defense cuts, discretionary spending reductions
Top two brackets return to 2001 levels; phase-out of itemized deductions; some discretionary spending cuts; Medicare reimbursement freeze
Discretionary and entitlement cuts (CPI chain weighting), limit on itemized deductions, "bracket creep" (faster migration to higher tax brackets)
All tax cuts return to 2001 levels; AMT no longer indexed to inflation; Medicare reimbursement cuts to Doctors proceed as planned
Tax rates lowered, combined with reduction in deductions to generate net tax revenue increase; cuts to discretionary and entitlement spending

Source: CBO, news reports, Gang of Six proposal, J.P. Morgan Private Bank.

¹ On the AMT: the Tax Policy Center estimates that if the AMT is not indexed to inflation, it would impact 31 million filers in 2012 (and raise $132 billion in revenue), compared to 4 million filers in 2011 (and $39 billion in revenue).
² For example: the Gang of Six state that they used the President's budget as a baseline (scored by CBO in March 2011), reduced deficits by $3.7 trillion, and ended up with a 71% debt/GDP ratio; but they do not explain how they get to the President's baseline in the first place.

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