A shutdown seems increasingly likely but is far from inevitable

“I’ve been there before
And I’ll try it again
But any fool knows
That there’s no way to win

– Ray Charles and Norah Jones — Here we go again

It’s that time of year again: There is a tug-of-war in Washington over the budget and we have been reading warnings of a government shutdown for weeks. The Democrats and Republicans will ultimately reach an agreement, but, as one writer observed, “The only question is what chaos will ensue before that happens. And we’re on a path for maximum chaos, have no doubt.”

Will there indeed be political pandemonium in Washington at the end of this month?

Before the summer, the Democrats and Republicans reached an agreement on raising of the debt ceiling (in the aftermath, the U.S. received a credit rating downgrade from Fitch), but this also included agreements on the budget. It set funding levels that kept non-military spending for fiscal year 2024 roughly flat from this year while setting a 1 percent cap on spending hikes for fiscal year 2025. 

In their new budget proposals, however, some House Republicans want to cut spending more than agreed in the debt ceiling deal, arguing that the original deal contained too many accounting tricks and yielded too little in real savings.

However, the House Freedom Caucus and some other representatives are not just concerned with the level of spending; they also impose all manner of other conditions for their consent, including tougher border policies, limits on aid to Ukraine and an end to what they see as out-of-control “woke” policies in the Pentagon and the so-called weaponization of the FBI and the Justice Department.

At this point, there seems too little time to agree on the 12 spending bills that are supposed to finance the government. As a result, a stopgap solution seems to be the only way out, which is known as a “continuing resolution.” However, it is not certain whether such a temporary solution will be passed by the House, and how much time it will buy them.

Interestingly, a budget could basically pass through the House and Senate and the president without any problems when it comes to the number of votes. In the Senate, the two parties sufficiently agree with ample majorities. Many Republican senators are even willing to allow additional expenditure on top of the agreed maximums in June. And House Speaker Kevin McCarthy (R-Calif.) could also secure the necessary votes in the House via the Democrats and the moderate Republicans in his group.

However, McCarthy’s House speakership lies in the hands of the more radical wing of his party. He needed 15 rounds of voting just to secure the gavel. To achieve this, he had to make many concessions, including that a single representative could now call for a vote to remove and replace McCarthy as Speaker. One of the figureheads of the more radical Republican representatives, Rep. Matt Gaetz (R-Fla.), has already made it clear that he wants to regularly call for McCarthy to be dismissed by starting “every single day in Congress with the prayer, the pledge and the motion to vacate.“

McCarthy has tried to placate these elements within the GOP with the announcement of an impeachment investigation into President Biden. He probably wants to achieve nothing other than a trade-off; the impeachment gesture in exchange for compliance in the budget negotiations. And, at the same time, it would not be inconvenient for him that an impeachment investigation would keep the far-from-pleasant affairs surrounding Hunter Biden in the spotlight.

Various Republican hardliners have already made it clear that they will not be bought off and that they will not budge an inch in the budget battle.

In short, it means that McCarthy has enough votes in the House to keep the government doors open with a temporary measure. However, without any support from the Freedom Caucus, his House speakership appears to be in jeopardy. Moreover, in the run-up to next year’s elections, voters will be presented with a picture of a deeply divided, rudderless party.

Most researchers, banks and columnists, therefore, assume that the government will have to close its doors for at least a few days, if only because this would enable McCarthy to gain some credits with the radical GOP wing.

A shutdown still isn’t inevitable (although time is running out fast).

During the debt ceiling fight, the Republican groups in the House and Senate were far more closely aligned. At this point, only a relatively small minority in the House is digging its heels in.

Moreover, whatever threat the hardliners pose, McCarthy may actually view it as a greater threat to his own power if he gives in to them, as this may increase dissatisfaction with his leadership among the far larger, moderate part of his group.

Moreover, it will be very difficult for Republicans to blame Democrats for a shutdown. Democrats and Republicans in the Senate are largely working together to keep the government’s doors open. In the House, it is clearly the Republicans who are obstructing things.

If the Freedom Caucus actually causes a shutdown, it could backfire, as the debt ceiling deal states that 1 percent cuts (mostly defense cuts) will automatically take effect if the government is still functioning under a continuing resolution by Jan. 1.

The budget plans supported by the Democrats and Republicans also include billions in emergency aid for Hawaii, for example. If these billions do not materialize due to the actions of the GOP, this will provide an excellent PR moment for the opposition.

Finally, the right wing is asking for major concessions, but they are not (yet) united around one clear list of demands. This may also make it easier to divide the bloc.

Despite the aforementioned arguments pleading in favor of a last-minute deal, we cannot rule out a shutdown for three reasons:

• A deal still seems far away and there are very few days left to reach an agreement.
• The right wing of the GOP has, on more occasions than one, shown that it does not shy away from taking far-reaching actions. And many Freedom Caucus members will focus not so much on the effect their decision has on the national polls, but rather on their position in their own state. For example, the aforementioned Gaetz represents a very conservative part of Florida, a state that has increasingly shifted to the right. The blunt axe that some Republicans are using actually appeals to many voters in such places. 
• A shutdown may look very radical, but it is still far more manageable than breaking the debt ceiling. The lower stakes mean that some members of Congress will be more willing to go over the edge.

Suppose the government doors are closed, will this result in a broken nose, or will it only cause a minor nosebleed?

Research by Goldman Sachs, for example, shows that the pain will probably not be too bad. Although the government accounts for a quarter of U.S. GDP, the impact of a shutdown will only affect a relatively small part of the government’s share in the total economy.

First of all, a shutdown exclusively concerns so-called discretionary government. This makes up “only” 6-7 percent of U.S. GDP. Second, a shutdown has little direct effect on investments and consumer spending. The direct effect is mainly visible in delayed payments to public servants, but federal wage payments represent only 2 percent of GDP and, moreover, many federal employees will be able to continue to work and will continue to be paid. Also, the negative impact of past shutdowns was usually offset in the ensuing period by a boost to economic growth.

Given the above, it will not be surprising that financial markets did not pay too much attention to previous shutdowns. However, it is certainly not a given that the markets will react the same this time. America has faced two credit downgrades, prospects for U.S. debts and deficits are dire and political polarization has only increased. A shutdown could therefore still prompt some investors to wonder about long-term prospects for the U.S.

Finally, it is important to know that if a deal is reached before Oct. 1, it will most likely only be for a few weeks or months, which means that we might end up in the same situation later this year.

Andy Langenkamp is a senior political analyst at ECR Research, which offers independent research on asset allocation, global financial markets, politics and FX, and interest rates.