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Would a US Default Mean Disaster?
07/19/2011 9:05 am EST
Failure to raise the debt ceiling would inflict immediate pain on many Americans and long-term damage to the nation’s finances. But there’s a chance the fallout could be far worse.
President Barack Obama says a failure to raise the US debt ceiling would be Armageddon.
“The idea that this is catastrophic is wrong,” Sen. Tom Coburn, R-Okla., 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 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 US economic growth, increase inflation, and ultimately cost the United States its AAA credit rating are all true, but they don’t add up to an ultimate end-of-the-world battle.
The inability to deal with something as relatively simple as raising the debt ceiling is a symptom of fiscal dysfunction in Washington, which will push the US 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 that heats up so slowly the frog never jumps out. Not fire blasting from heaven to devour Gog and Magog.
Mind you, there is a possibility that 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.
Come to think of it, it couldn’t be that second reason, though—Wall Street and Washington would be fine showing everyone how the sausage is made. Really, they would.
Understanding the Problem
The problem posed by the debt ceiling is actually 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, the monthly deficit hit $223 billion, which was a record.
May, a very good month for revenue inflows, saw the lowest deficit for that month in five years—but that deficit still hit $59 billion. It was also the 32nd consecutive monthly deficit.
The cumulative red ink pushed the federal government right up to the current debt ceiling of $14.29 trillion on May 16. The US Treasury has been juggling accounts ever since—by, for example, delaying internal transfer payments—but it 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.
Going cold turkey on debt is made more difficult because some parts of federal spending are climbing automatically. As of May, spending formulas increased the cost of Social Security, Medicare, and Medicaid in 2011 by 3.6%, 3.8%, and 5.4% over 2010, respectively, 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 US 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.
NEXT: The Consequences of Failure|pagebreak|
The Consequences of Failure
Here are the five arguments Obama is making for raising the debt ceiling:
- First, at least one core function of the US government—with lots of public support—is going to take a big hit if the United States suddenly has to live within its revenue.
What’s it going to be? Social Security? Veterans’ benefits? Pay for active-duty military personnel? 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. Even combined, they’re peanuts compared with that $125 billion gap.
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 US economy back into recession.
In the first quarter of 2011, the US economy showed a 1.9% annual real rate of growth (after subtracting the effects of inflation on the value of goods and services produced here).
That resulted in the US economy growing (once again after subtracting inflation) by a whopping $64 billion. That’s only about half as big as the monthly cuts that would be necessary to fill the revenue gap in the event of a failure to raise the debt ceiling.
Yes, in the long run the US debt of $14.3 trillion is a powerful drag on growth in the US economy. But in the short run, reducing the government’s spending by $375 billion a quarter in borrowed money will 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 the United States must pay on its debt.
Stands to reason, doesn’t it? US Treasuries have been used as the definition of a risk-free investment, because buyers could count on the US always paying its bills and behaving somewhat responsibly. Now both of those attributes deserve serious re-examination.
And even if Congress does come up with a deal that extends the debt ceiling, major damage has already been done to US credibility.
Imagine that you’re an overseas investor following the current debate in Washington. You’ve heard US politicians say that 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 US dollar.
Standard & Poor’s has put the US AAA rating on credit watch with negative implications. The credit-rating company has said that if a credit downgrade happens, it could come within the next three months.
This, like the uncertainty surrounding the debt ceiling fight and the demonstrated inability of US politicians to come up with a plan for addressing the long-term US debt problem, has eroded the desire of overseas investors to hold dollars.
Until Washington can demonstrate a real plan to reduce the projected growth in US debt, I think the dollar will be locked into a downward trajectory. That adds to the upward pressure on US interest rates, of course, as well as the downward pressure on the US 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.”
Even then, US interest rates are likely to climb slowly, because Treasuries are such a big part of the global portfolio that it’s hard to find alternatives overnight. (Nonetheless, the US debt-ceiling crisis, like the larger US debt crisis, is good for gold and other commodities, as well as currencies such as the Canadian and Australian dollars, the Swiss franc, and the Norwegian krone.)
NEXT: No Armageddon, But…|pagebreak|
No Armageddon, But...
I think we’re looking at a gradual worsening of the US global financial posture. But that doesn’t count as Armageddon, because that’s pretty much what investors have been looking at for years. Do you know anyone who is surprised at this trend?
My big worry is that the current slow erosion of faith in US Treasuries will turn into a cascade of unanticipated consequences if the debt ceiling isn’t raised.
Treasuries play a unique role in the global financial markets. They aren’t important only 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.
It’s that role that makes me think Armageddon is a possibility. It’s a remote possibility, I think. But given the very limited information about these markets and the balance sheets of the players, I can’t say with any degree of certainty how small the possibility might be.
A Look at the Repo Market
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 a specified date in the future. Repos are, in effect, short-term loans; they 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 decreases the repo rate at which it buys back government debt instruments from commercial banks. To shrink the money supply, the Fed increases 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 (JPM) or the European Central Bank to have exposure to this market. Money-market funds have big chunks 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 on using money-market funds as a safe haven in the event of a US 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 US Treasury debt is used to back deals.
The truth, though, is that no one knows exactly what it would take to trigger problems in one or more of these markets. We do know, though, that Wall Street is worried.
The Financial Times has reported that Matthew Zames, an executive at JPMorgan Chase and chairman of the Treasury Borrowing Advisory Committee, wrote in April to Treasury Secretary Timothy 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 July 15, the Securities Industry and Financial Markets Association held a meeting with staff from the big banks to discuss the effects of a US default on those markets.
NEXT: Watch the Ripples|pagebreak|
Watch the Ripples
The ripples from any default or downgrade of the US 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, sell other assets, or close their repos and other positions.
And that would set off a wave of deleveraging, very 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 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 it was then. Very little has changed that would prevent a replay of that crisis.
To me, such a rerun 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 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.
Why Didn’t They Fix This?
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 a failure to raise the debt ceiling and a downgrade of the US 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 column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. The fund did own shares of Home Inns and Hotels Management and Mindray as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.
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