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Management by committee is an oxymoron

November 18, 2011: 12:38 PM ET

If the debt super committee misses its deadline of November 23rd, the debt ceiling will still get extended and automatic cuts will go into effect -- a positive for the U.S.

By Daryl G. Jones, Hedgeye

"I think this super committee is about as dumb an idea as Washington has come up with in my lifetime. I used to run the House of Representatives.  I have some general notion of these things. The idea that 523 senators and congressmen are going to sit around for four months while 12 brilliant people, mostly picked for political reasons, are going to sit in some room and brilliantly come up with a trillion dollars, or force us to choose between gutting our military and accepting a tax increase, is irrational."

--Former Speaker of the House and current Presidential candidate, Newt Gingrich

As many of us who manage businesses or portfolios know full well, decision making by committee looks great on paper, but is typically ineffective in practice. As if a committee wasn't bad enough, the Joint Select Committee on Deficit Reduction (the "Super Committee"), which was created by The Budget Control Act of 2011, is comprised of twelve politicians (six from each party).   It should be no surprise then that the Super Committee is likely going to have a difficult time meeting its November 23rd deadline.

In the table below, we've outlined the key members of the Super Committee, which is comprised of six Democrats and six Republicans. Setting aside our legitimate concern that the Super Committee meetings are being held behind closed doors by non-democratically elected members of a sort of super Congress, we would be even more concerned if we believed the group could actually reach a resolution. Given the highly partisan nature of Washington these days, we find it very unlikely that a compromise is reached or that any member of the Super Committee crosses party lines to reach a resolution.

According to InTrade, there is currently a ~15% chance that the Super Committee issues a recommendation on $1.5 trillion of cuts by midnight on November 23rd. To be fair, the odds have increased from 10% in early November, but still remain well off the 50% odds from mid-to-late October.  This implies worse than a one in six chance that a recommendation is made prior to the deadline.

The goal of the Super Committee is to agree on a plan for $1.5 trillion in deficit reduction over the next ten years. If reached, the plan is then sent to Congress, where it is to be voted on by a simple up or down vote. As such, it is not subject to amendments, "majority of the majority" blocks, or Senate filibusters. After the simple majority votes in each house, the bill will then be sent to President Obama to sign. The deadline for Congressional approval is December 23rd.

In the scenario that no agreement is reached by December 23rd, $1.2 trillion in spending cuts will be implemented across-the-board starting in January 2013. (There would be no automatic revenue increases.)  These budget cuts are more commonly known as sequestration. These cuts would exclude:  social security, Medicaid, veterans' benefits, food stamps, and some other aid programs. The key focus of these automatically implemented cuts would be the defense budget and discretionary spending, with a 50/50 split between each. The White House has explicitly stated it will block any measures to water down the sequestration enforcement mechanism.

Preliminary estimates suggest if the automatically implemented cuts were to go into effect, a 7.8% average reduction would hit non-defense discretionary spending. This is compared to annual growth rate of discretionary spending from 1971 to 2010 of 6.4%. In fact, the only year-over-year decline occurred in 1996 with a 2.2% decline, which is highlighted in the chart below. So, even if the Super Committee fails, the future deficit will improve on the margin.

In terms of impact on U.S.'s credit rating and potential for a default in the short term, a second debt ceiling increase of $500 billion is scheduled to go into effect regardless of whether Congress passes the Super Committee's proposal. The process for the debt ceiling extension is that the President must request a further increase from Congress. This request is subject to a motion of disproval. The President can veto the motion and Congress can then override his veto by a two-thirds majority. In all likelihood, this debt ceiling increase will pass. Based on the projected deficit math, the second debt ceiling will allow borrowing to continue at current levels through the 2012 Presidential election, so there is no imminent risk of a downgrade on this basis.

The emerging outcome for the Super Committee seems to be some form of a two-step process given the current divide between Republicans and Democrats on the Super Committee.  In fact, Republican co-chair Texas Rep. Jeb Hensarling stated as much on CNN when he said:

"There could be a two-step process that would hopefully give us pro-growth tax reform."

Not surprisingly, the divide is squarely across partisan lines with the Republicans currently unwilling to accept any increase in taxes and the Democrats just as unwilling to accept any major alteration in entitlement spending. Indeed, while the Republicans have offered a proposal of $1.4 trillion in deficit reduction, it includes $500 billion in new revenue from capping individual deductions while cutting all six income tax rates by 20%.  In addition, it would extend the Bush-era tax cuts.

As is typical for politicians, the likely outcome of the Super Committee is that the can will be kicked down the road, even if they reach some two-step compromise.  As previously stated, though, this is not all negative as the deficit enforcement mechanism will kick-in, which is, on the margin, positive for U.S. deficit reduction.

Follow Daryl Jones on Twitter @HedgeyeDJ.

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Hedgeye

Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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