Danger Is Rising Rapidly in Debt Ceiling Issue

by futurist Richard Worzel, C.F.A.

My last blog dealt with the debt ceiling debate within the U.S. Congress – if “debate” is the word for what looks like a combination of Mexican stand-off and Russian roulette. I’d like to update my comments with some things to watch:

1) August 2nd is probably not the deadline. I believe the actual deadline is unknown, and uncertain. If the rating agencies drop the credit rating on US debt, or the markets start to panic, that will start a chain of events that will probably be irreversible, and trigger a US default. Yet there is a real danger that all three parties involved in this mess (Republicans, Democrats, and the President) actually believe that they have until August 2nd to back away from the abyss. In fact, the ground may collapse under their feet while they’re still posturing on the edge.

2) Suppose that the Speaker of the House of Representatives (John Boehner) and President Obama do arrive at a deal in time. What they may not be counting on is hold-ups by others, such as a defeat of their deal by ideologues within the Republican party in the House, or a filibuster by a disgruntled ideologue of either party in the Senate. This could prevent a deal from passing in time, and could trigger the events described in point 1 above.

3) Even if a deal is struck before panic happens, this event has already caused significant damage, and we won’t know the extent of that damage for months or years. As one of the commentators I follow, a retired money manager who keeps tabs on things for his own interest, put it in an email to me: “a great deal of damage has already been done. Anyone who would have said a year, or even six months ago, that there would be major talk of the US defaulting would have been laughed out of the room. Foreign investors, incl. the central banks, are already ‘voting with their feet’, as witnessed by the price of gold that this morning leapt through the 1,600 level and the fact that last week was the 16th month in succession that assets under management dedicated to emerging market bonds funds were up.” In effect, the United States government has called its own credibility into question, and announced loudly to the world that it is dysfunctional and untrustworthy on financial matters. US debt is no longer “risk free”, and investors will hereafter try to find other, less schizoid places for their money, which will cause U.S. interest rates to rise, further exacerbating the U.S. deficit by increasing interest costs. This is an incredibly dumb action by the U.S. Congress, notably the brain-dead ideologues in the Republican Party.

4) There are members of the Republican party that are saying they won’t vote raise the debt ceiling under any circumstance, which is an ideological statement, not a rational one. There are Republicans who are saying a default would not be as bad as Obama is saying, that he’s fear-mongering. That’s a clear illustration of their ignorance. There are even Republicans who are saying that default would be a good thing because it would force liberals to cut spending – completely overlooking the fact that it would dramatically raise the interest rates the US government would pay, which would raise the total interest costs, which would increase the deficit. It is truly frightening that our collective future is at the mercy of such idiots. Moreover, if a default happens, these same idiots will blame Obama because they always blame Obama.

5) There are only two small pieces of good news of the last week or so. First is that while the American public is condemning all sides on this issue, its greatest condemnation is for the Republicans fanatics. Hopefully this will scare them enough that they will rethink their positions. The other is the bizarre, Rube Goldberg-ian mechanism proposed by Senate Minority Leader Mitch McConnell. In effect, it would allow Republicans to vote to give Obama the power to overrule them and raise the debt ceiling. They think that this is somehow different from voting to raise the debt ceiling. The only thing to recommend this wacko idea is that it might lead to the debt ceiling being raised, and rescue the Republicans from themselves.

6) So far, most Democrats have been remarkably silent (or at least unnoticed), but I suspect that some left-wing ideologues will say they won’t vote to raise the debt ceiling if Social Security, Medicare, or Medicaid are affected by cuts. These people are as dangerous as the Republican fanatics. The US has no choice but to cut its deficit, as I’ve written elsewhere. Any such Democrats are idiots, too, if they hold to this position.

7) Some have suggested that President Obama has the power to raise the debt ceiling without Congress by virtue of Section 4 of the 14th Amendment, which says “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” First, I don’t find this unequivocal, but more importantly, how many investors would be willing to take a chance on buying debt that may not be legal, and might subsequently be declared invalid by the U.S. Supreme Court? I think this is a non-starter.

8) The financial markets aren’t reacting more because they don’t think that the Republicans are serious about refusing to raise the debt ceiling, while the Republican fanatics assume that the markets don’t care. Meanwhile, the bond market is torn because investors are so concerned about what’s happening in the EU that many are fleeing to US Treasury issues. Where else is there to go? Both of these effects leave the impression that things are better than they actually are – and may given the parties involved in negotiation more time before a panic occurs.

9) Most of the reactions I’ve had to my blog have been wishful thinking, along the lines of “This can’t happen. This is all posturing. They’ll come to an agreement.” I certainly hope so, but I’m not seeing signs of it. I can only hope that there is real progress being made in the back rooms on this, because everything I see in public pronouncements indicates two sides that are too far apart to reach a deal. And, by the way, through this and other of my blogs, I’ve been ripped as being both a tool of the Republicans (by liberals), and a tax-and-spend liberal (by conservatives). I guess I must be doing something right.

Possible calendar of events to default – or avoidance thereof

Let me offer a possible timetable of events for avoiding a default. Anything worse than this must, I think, lead to default. Anything better may avert it, although that’s not certain:

Thursday, July 21st, 2011 – Markets begin selling off in earnest as time runs out to craft, draft, pass and sign legislation permitting the debt ceiling to rise. (Foreign exchange markets are already starting to move.)

Monday, July 25th, 2011 – One or both of the rating agencies offer one last warning, saying that a ratings downgrade is imminent unless a deal emerges to raise the debt ceiling. As well, both agencies emphasize that raising the debt ceiling alone is not enough; the deficit must be tackled in a realistic manner as well.

Wednesday, July 27th, 2011 – Congressional leaders and President Obama announce the outlines of a deal, forced on them by falling markets, plus a fast-tracking process to get it through both houses of Congress in time. Markets have dropped by about 8% from a week earlier, or more than 1,000 points on the Dow Jones Industrial Average.

Friday, July 29th, 2011 – Grandstanding Republican fanatics try to stall or fatally amend the legislation, but are slapped down by Republican leadership. The bill clears the House.

Monday, August 1st, 2011 – Members of both parties attempt to filibuster, delay, or fatally amend an identical bill in the Senate, but are voted down by combined Republican and Democratic Senators. The bill clears the Senate.

The bill goes to Obama to sign. He signs it with the media watching, and thanks leaders of both parties and in both houses of Congress. He also announces a task force with members from both parties to come up with $1.5 trillion in budget cuts and revenue increases over the next 10 years, such cuts to be enacted by the end of 2011, plus a secondary goal of recommending budget cuts and tax code revisions amounting to $4 trillion over the next 12 years, to be enacted after the elections of 2012.

The Federal Reserve announces a special debt issue to provide the government with immediate cash, which it purchases from the Treasury, pending a successful new public bond issue. Critics call this “QE3”, but it’s really about the only way the Treasury can get enough money fast enough to meet obligations – by having the Fed print it.

The markets rally slightly, then begin sinking again more slowly on the continuing crisis in Europe and the weak economy in America. Moody’s and Standard & Poor’s maintain their negative watch on the US credit rating.

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Is this the way it will happen? Certainly not. First of all, I don’t know enough about the process of passing legislation through the US Congress, but I do know that the Treasury Secretary has said they must have a deal by July 22nd in order to get the legislation done. Moreover, there are too many aspects of this very complex future for me to successfully get them right. What I’ve tried to do is come up with an at-the-last-moment scenario to use as a benchmark to see how the process is going. As I said, if the process lags behind this, then a default seems likely.

Just so you know, I am backing my words with actions. I have, at this point, sold or am in the process of selling all of my investment holdings except for (a) precious metals, and (b) a small investment in developing economies. I may sell both of these positions before the dust settles. I am also trying to minimize my holdings of US dollars.

 

© Copyright, IF Research, July 19th, 2011.