The Shutdown Talks Are in Chaos

A lot of readers, when we’ve discussed the budget/shutdown/debt ceiling negotiations, have done the equivalent of declaring it all to be kabuki, that the fix is in.

While I have no doubt that any resolution of this impasse is certain to make matters worse for what is left of the endangered species known as the American middle class, what is going on in DC is not a pretty scripted stagefight. The negotiations are in a mess. Anyone who says they know where things are or what the outcome will be is kidding themselves.

This has all the signs, even from what little that can be seen with confidence, of a negotiation that has gone off the rails. Relations between the principals, which in this case was Obama and Boehner have broken down. Senators Harry Reid and Mitch McConnell are trying to broker a deal Both sides have rejected each other’s version of what they think is a clean and simple deal. Obama insists on a clean continuing resolution (as opening the government) and a clean lifting of the debt ceiling. The Republicans were willing to only push out the debt ceiling limit to only to November 22, which Obama rejected. McConnell then offered to Reid to increase the debt ceiling through January and keep the government operating until March, but Reid nixed that.

The New York Times reports:

The core of the dispute is about spending, and how long a stopgap measure that would reopen the government should last. Democrats want the across-the-board cuts known as sequestration to last only through mid-November; Republicans want them to last as long as possible.

The Democrats’ demand shows a newfound aggressiveness. Previously, they had favored a so-called clean bill that would reopen the government and lift the debt ceiling without any policy changes attached. With Republicans on the defensive, it remains unclear whether the Democrats are using a negotiating ploy to raise the likelihood that any final deal will include their priorities as well as the Republicans’…

The dispute may involve debt ceiling technicalities, but at the core of the fight is a more fundamental question: with polls showing that Republicans are carrying the brunt of the blame for the shutdown, can Democrats demand total surrender, or should they offer concessions to complete the deal?…

The Collins plan would maintain sequestration-level spending through Jan. 15, when formal budget negotiators would be required to complete a House-Senate agreement on spending and taxation over the next decade. That date was already a concession. Ms. Collins, along with Senators Kelly Ayotte of New Hampshire and Lisa Murkowski of Alaska, both Republicans, initially wanted to finance the government for six months at those levels. The initial proposal by Ms. Collins would also have extended the debt ceiling only to Nov. 15, but at the request of Senate Democratic leaders, she and Mr. McConnell pushed it back to Jan. 31…

But Democratic leaders have balked, and they flexed their muscle Sunday with a group of Democratic and independent senators negotiating with Ms. Collins.

The reason this is not pretty is that things get ugly starting Thursday at midnight, when Treasury says the debt ceiling starts to bind. Neither side is even close to an outline of terms (what in the private sector we call a “letter of intent” where both sides agree on the key deal points and go off to draft detailed terms, which in this case would be the language for a bill). The Senate has cumbersome procedures, so a bill can’t be passed in a mere few hours. This means we are in time is of the essence mode. Yet we have acrimony on both sides (the Democrats believe Boehner has operated in bad faith, which is poisonous for negotiations, but they don’t want to dislodge him because any replacement is likely to be even more difficult to work with). We also appear to be not at all close to agreeing on an outline for a deal.

While the magic date of Thursday does not mean a default happens then, what it almost certainly means is the government goes into a more severe shutdown mode to conserve more cash, which will cause more disruptions. As bad as that is, the real critical date is around October 31-November 1. Even then I don’t see this Administration defaulting on Treasuries, it will sacrifice pretty much everything it can to do that. But some investors may not believe that, and if retail investors start exiting money market funds with Treasury exposures (even though fund managers have exited the particular bonds that would be at risk) we could see serious disruption to the repo market (money market funds are big investors in repo). Remember, a run is destructive whether the fear is well founded or not.

Now I don’t anticipate that things will go that far (and if anything were to get ugly, you could also expect this Fed to use its unusual and exigent circumstances powers to intervene). But it looks as if the Dems are willing to use Mr. Market to cow the Republicans. And as an aside, this should belie the commonly-touted Democratic cover for Obama that he is weak. He’s only pretended to be weak to shift blame to the Republicans for what he wanted to do when what he wanted to do entailed selling out his base.

At least as of now, the Democrat posture has become to add demands at a late stage. That is a Mafia bargaining tactic, when you believe you are making an offer they can’t refuse. The Democrats believe that they can push the Republicans because they are suffering a much bigger hit than the Democrats in the polls over the budget impasse. And the longer the delay, the only thing that it will be possible to negotiate and pass is something with hardly any moving parts. That also favors the Democrats.

Keep in mind also that market mood has played a big role in the seriousness of the talks. When the stock market has rallied on the hopes that a deal is on track, then the talks start to go awry, and when Mr. Market has gotten upset, the negotiators at least make credible noises that the discussions are on track. Who knows whether the Congresscritters are more worried about their own portfolios or those of their big backers, but either way, falling stock prices do seem to focus their minds.

S&P futures have been down about 11 points, which is not a freakout level move, and bond market trading will be thin today since it’s a bank holiday. So unless the stock market decays further during the day, I’m not sure Mr. Market will apply enough pressure to move the negotiations forward today. But another day of impasse risks a big increase in collective anxiety levels. Both parties are going to be under big pressure to have some sort of deal in principle by Thursday, even if they don’t have it passed by both houses and ready for Obama’s signature. If the two parties can announce a deal by Thursday, a likely date when it will be wrapped up, and how Treasury will manage things until the debt ceiling has been lifted, that would probably do. It would be messy but workable. But getting to there from where we are now is a very big task.

And some further things to keep in mind: this fight is in danger of becoming a cliffhanger, yet it is also planned to set the stage for the big deficit-cutting deal which the Democrats and traditional Republicans intend to cut social safety nets, most importantly, Social Security and Medicare. We’ve discussed at considerable length in earlier posts why trying to reduce government spending is not a good idea (we aren’t even close to the conditions where it might be warranted), how the projected Medicare cost increases, which are the lynchpin for the debt scaremongering, are considerably overstated, and how cutting deficits now will worsen, rather than improve, the government debt to GDP ratio. The rich might think that they will profit from this auto da fe is the rich, and they are likely to suffer too.

But Obama and Boenher could not get a deal done in 2011, when conditions were much more favorable. The Democrats now see the Republicans as bad faith actors. In the last round of talks, where the Democrats rejected the Collins offer, the Republicans are making it clear they are feeling bruised and badly used by the Democrats. It doesn’t matter whether all these hurt feelers are objectively justified. What it does mean that if Obama and the Democrats win by pushing the Republicans against the debt ceiling wall and wrestling a capitulation from them, that short-term victory could well poison the negotiations over a Grand Bargain. Parties that distrust and dislike each other have trouble coming to any sort of agreement, particularly complicated ones. That is perversely the best hope for ordinary Americans, that Obama wins this battle and in so doing, loses his Grand Bargain war. But don’t hold your breath.

This piece is cross-posted from Naked Capitalism with permission.