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So what happens to you and me if Congress doesn't raise the debt ceiling? (And, yes, it could really produce financial Armageddon but not in the way that anyone is talking about now)
07/19/2011 8:30 am EST
“The idea that this is catastrophic is wrong,” Republican Senator Tom Coburn rejoins. On Meet the Press on Sunday, Coburn said, “What is catastrophic is to continue to spend money we don't have.” Besides, he added “the debt limit doesn't really mean anything because we've always extended it.”
Well, which is it? A failure to extend the debt ceiling would seem like it is either a catastrophe or not. You can’t be just a little bit “Armageddon” any more than you can be a little bit pregnant.
Frankly I think the catastrophe claim is justified—but not on the evidence that anyone is offering.
Arguments that a failure to raise the debt limit will raise interest rates, slow U.S. economic growth, increase inflation, and ultimately cost the U.S. its AAA credit rating are all true but they don’t add up to an ultimate battle at the end of days. The inability to deal with something as relatively simple as raising the debt ceiling is a symptom of fiscal dysfunction in Washington that will push the U.S. further down the road to economic stagnation. But the image that comes to my mind is that of a frog cooking to death in a pot of water heating up so slowly that the frog never jumps out rather than fire blasting from heaven to devour Gog and Magog.
There is, mind you, the possibility that a failure to raise the debt ceiling could set off a catastrophe in the financial markets along the lines of the Lehman Brothers meltdown. But no one seems to be talking about how that could happen—maybe because it’s too complicated for us rubes to understand or maybe because it’s another example of why the current system of global finance needs to be torn down and completely rebuilt. Couldn’t be the second, of course, since Wall Street and Washington would be fine showing voters how the sausage is made. Really, they would.
The problem posed by the debt ceiling is really pretty simple. Every month the United States takes in less than it spends. The gap has averaged $125 billion a month in 2011. In February 2011 the monthly deficit hit $223 billion, a record. In May, a very good month for revenue inflows—the month saw the lowest deficit for May in five years--the monthly deficit still hit $59 billion. (It was the 32nd consecutive monthly deficit.) That pushed the federal government right up to the current debt ceiling of $14.29 trillion on May 16. The U.S. Treasury has been juggling accounts ever since by delaying internal transfer payments, for example, but the Treasury will run out of gimmicks on August 2, according to its calculations. At that point the federal government will have to stop spending more than it takes in—unless Congress raises the debt ceiling to allow more borrowing.
Suddenly going cold turkey on debt is made more difficult because some parts of federal spending are climbing automatically. As of May, spending formulas had increased the cost of Social Security, Medicare, and Medicaid by 3.6%, 3.8% and 5.4% in 2011 from 2010, according to the Congressional Budget Office. The biggest jump came from spending on the public debt, up 16% from 2010.
If the Treasury can’t juggle cash internally to avoid running up against the debt ceiling, then it will have to juggle externally to bridge the average $125 billion monthly gap. In June the interest due on the U.S. debt came to $110 billion but most months it’s closer to $30 billion. The government sent out about $60 billion in Social Security checks in May. Not sending out Social Security checks and not paying interest on Treasury debt would go a long way to closing the monthly gap.
Here’s where you get to the argument that President Obama is making for raising the debt ceiling.
First, a core function of the U.S. government—one with lots of public support—is going to take a big hit if the United States suddenly has to live month to month within its revenue. What’s it going to be? Social Security? Veterans’ benefits? Pay for active duty military personal? Interest on Treasury debt? Want to avoid hitting a big, politically powerful group hard in your efforts to fill the gap? Can’t be done. Eliminating the entire budget for the Smithsonian museums, for example, would save just $800 million over a year or about $67 million a month. Completely zero out the NASA budget and you reduce the gap by about $1.6 billion a month. Cut the Environmental Protection Agency’s budget completely and the monthly gain is $750 million. Nope, to close the gap, you’ve got to go after the big programs that have been responsible for bringing the current negotiations over the debt ceiling to deadlock.
Second, cuts of this magnitude will, in the short term send the U.S. economy back into recession. In the first quarter of 2011 the U.S. economy showed a 1.9% annual real rate of growth. (That is after subtracting the effects of inflation on the value of goods and services produced in the United States.) That resulted in the U.S. economy growing (once again after subtracting inflation) by a whopping $64 billion. That’s about half as big as the cuts to fill the revenue gap in the event of a failure to raise the debt ceiling would require every month. At 1.9% growth the U.S. economy grew by $64 billion in the three months of the first quarter. To fill the gap, the U.S. government would have to reduce spending by $375 billion. Yes, in the long-run the U.S. debt of $14.3 trillion is a powerful drag on growth in the U.S. economy. But in the short-run, reducing the government’s spending by $375 billion a quarter in borrowed money will act to depress economic growth.
Third, trying to run a government without either a surplus or the possibility of adding additional debt to balance out month to month swings in revenue and spending will produce massive uncertainty. So what does Treasury do when interest payments balloon in June and December as they do every year? Does the government cut back on interest payments even more that month and then increase payments in January and July? Tax receipts don’t come in evenly over the course of a year either.
Fourth, all this uncertainty and chaos will add to the interest rates that the United States must pay on its debt. Stands to reason doesn’t it? U.S. Treasuries have been used as the definition of a risk-free investment because buyers could count on the U.S. always paying its bills and on the U.S. to behave reasonably responsibly. Now both of those attributes deserve serious re-examination. And even if the U.S. Congress does come up with a deal that extends the debt ceiling, major damage has been done to U.S. credibility. Imagine that you’re an overseas investor following the current debate in Washington. You’ve heard the U.S. politicians say a default is better than raising the debt ceiling. You’ve heard statements that have basically challenged you to find another place to put your money. And you’ve seen politicians willing to sacrifice bond investors to short-term domestic politics. Every investor in the world has got to be asking, How soon can I find an alternative investment for some of my Treasuries?
Fifth, none of this is good for the long-term trend in the U.S. dollar. Standard & Poor’s has put the U.S. AAA rating on credit watch with negative implications. The credit rating company has said that a credit downgrade—if it is coming—could come within the next three months. This, like the uncertainty surrounding the debt ceiling fight and the demonstrated inability of U.S. politicians to come up with a plan for addressing the long-term U.S. debt problem, has certainly eroded the desire of overseas investors to hold dollars. Until Washington can demonstrate a real plan to reduce the projected growth in U.S. debt, I think the dollar will be locked into a downward trajectory. That adds, of course, to the upward pressure on U.S. interest rates and the downward pressure on the U.S. standard of living.
All this adds up to serious pain for the average American. Even if you aren’t a member of one of the groups that winds up paying for a failure to extend the debt ceiling, you’re still going to pay the price in slower growth and higher interest rates.
But I don’t see Armageddon here. Interest rates won’t go up overnight. In fact they may not go up at all until the euro debt crisis is “solved.” And even then U.S. interest rates are likely to climb slowly because U.S. Treasuries are such a big part of the global portfolio that it’s hard to find alternatives overnight. (Nonetheless the U.S. debt ceiling crisis like the larger U.S. debt crisis is good for gold and other commodities and for currencies such as the Canadian and Australian dollars, the Swiss franc, and the Norwegian krone.) I think we’re looking at a gradual worsening of the U.S. global financial posture—but that doesn’t count as Armageddon since that’s pretty much what investors have been looking at for years. Do you know anyone who is surprised at this trend?
So no Armageddon unless…
Unless the slow erosion of faith in U.S. Treasuries turns into a cascade of unanticipated consequences because of the unique role that Treasuries play in the global financial markets. Treasuries aren’t just important because they’re jammed into so many global portfolios, including the portfolios of so many of the world’s countries. They’re also important because they serve as collateral on a huge percentage of the complex deals that use derivatives to shift risk around the globe. And it’s that role that makes me think that Armageddon is a possibility. A remote possibility, I think. But given the very limited information about these markets and the balance sheets of the players in these markets, I can’t say with any degree of certainty how small the possibility might be.
For example, Treasuries are used as collateral for cash loans in the repo (repurchase) market. In a repo agreement the seller of a security agrees to buy it back from a buyer at a higher price on as specified date in the future. Repos are in effect short-term loans and are used to raise short-term cash by banks and corporations. Central banks, such as the Federal Reserve, also use them to manage the money supply. To expand the money supply the Fed would decrease the repo rate at which it buys back government debt instruments from commercial banks. To shrink the money supply, the Fed would increase the repo rate.
It’s a huge market. Bank of America Merrill Lynch estimates that 74% of primary dealer repo financing—or about $2.1 trillion--involves Treasuries as collateral. And you don’t have to be JPMorgan Chase or the European Central Bank to have exposure to this market. Money market funds have big hunks of their cash in the repo market. (Anyone who remembers the problems that the Lehman crisis created for money market funds should regard any advice to use money market funds as safe haven in the event of a U.S. default with extreme skepticism.)
And this is just one of the markets that uses Treasuries as collateral. According to estimates by JPMorgan Chase about $4 trillion in U.S. Treasury debt is used to back deals.
The truth, though, is that no one knows exactly how much—or what it would take to trigger problems in one or more of these markets. We do know, however, that Wall Street is worried. The Financial Times has reported that in April Matthew Zames, an executive at JPMorgan Chase and chairman of the Treasury Borrowing Advisory Committee, wrote to Treasury Secretary Tim Geithner that “a default could trigger a wave of margin calls and a widening of haircuts on collateral, which in turn could lead to deleveraging and a sharp drop in lending.” On Friday, July 15, the Securities Industry and Financial Markets Association held a meeting with staff from the big banks to discuss the effects of a U.S. default on these markets.
The ripples from any default or downgrade of the U.S. credit rating would spread out like this. Investors who lent cash against Treasuries as collateral would require more bonds to back their loans. That would force borrowers to find cash, to sell other assets, or to close their repos and other positions. And that would set off a wave of de-leveraging highly similar to the one that swept the financial markets in the wake of the Lehman bankruptcy in September 2008. We could get a replay of the credit crunch that almost brought down global financial markets and the global economy in 2008. (And this time the Federal Reserve would be unable to ride to the rescue.)
As I say, I think that this is a remote scenario. But what troubles me is that almost three years after the Lehman bankruptcy the global financial system remains pretty much the opaque network of undisclosed and unregulated leverage that it was then. Very little has changed that would prevent a replay of that crisis.
To me a replay of that crisis would qualify as Armageddon—and that makes me wonder why nobody who is trying to get this debt ceiling deal done is explaining to voters this aspect of the danger that we all face. Maybe it is too complicated—not for voters but for the politicians who sit in Washington. Certainly we’ve seen a very convincing demonstration over the last few weeks of Washington’s abysmal level of understanding of finance and economics.
But I can’t help thinking that there’s something else at work. Neither party really wants to draw attention to the fact that they did so little to fix the system that produced the last crisis. The Republicans have concentrated on gutting a system of reforms, even before the regulations for them have been written, but nobody thinks the reforms being so tepidly defended by the Democrats in Congress and in the White House really get at the problems that contributed to the last crisis. Above all, I suspect, nobody wants to admit that the pain that a failure to raise the debt ceiling and a downgrade of the U.S. credit rating following a default would inflict on the average voter isn’t enough reason to reach a deal. But that worries from Wall Street might well be.
When the country remains as angry as it has every right to be about Wall Street’s ability to escape the consequences of the last crisis, I doubt that anyone in Washington wants to remind voters that the folks in D.C. listen to Wall Street and ignore Main Street.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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