Why the World Really May End on August 2nd, 2011

by futurist Richard Worzel, C.F.A.

The world as we know it may very well end on August 2^nd. This won’t be the end of the world in a metaphysical or spiritual sense, but rather in a financial and economic one because of the incredible, almost unbelievable stupidity of the extreme members of the Republican Party. These wing-nuts are using the financial equivalent of the threat of nuclear winter to negotiate their agenda of spending cuts, coupled with no tax increases or even tax cuts, to eliminate the U.S. federal deficit, or else. In this case, the “or else” is a refusal to raise the debt ceiling for the U.S. government. If that happened, then the U.S. government would run out of money by about August 2^nd, and begin to default on its obligations. There are two major aspects of this: financial, and political. Let me deal with the financial aspects first.

The debt ceiling is the maximum amount of debt that the U.S. government is allowed to borrow to finance it’s operations, and is legislation originating in the House, approved by the Senate, and passed by the President, like any other financial legislation. The U.S. government cannot borrow any money beyond this authorization. Given the current massive deficit being run up by the American government, this would force the U.S. government to default on its debt. Such a default would produce a vast disruption in the financial markets, and cause America’s credit rating to be downgraded from AAA to AA or less. This, in turn, would require many pension funds and other investment groups required to hold nothing but AAA securities to sell all of their holdings in U.S. government bonds and T-bills. This forced sale would trigger a panic on Wall Street, and in financial centers around the world. U.S. treasury bonds and T-bills are considered the most secure investments in the world – but then, suddenly, they wouldn’t be. Investors would have no idea what was safe, or where they should put their money. And the amount of U.S. securities held by investors, including countries like China, runs into the trillions. If there were a run on U.S. securities, it wouldn’t just be dramatic, it would be cataclysmic because there would be nobody to buy them.

And it wouldn’t just be the U.S. federal government. All of its agencies and the agencies it supports would be downgraded (and their securities dumped). And it’s quite possible that a number of state governments would also be downgraded as well. Indeed, as anyone who has studied financial panics of the past (as I have) knows, once a panic starts, the mob sells anything with any hint or rumor of possible financial difficulties. As a result, the panic would instantly spread to all of the shaky sovereign credits of Europe (Greece, Ireland, Portugal, Belgium, and more), and move into American state governments (Illinois, California, and more), and into corporations thought to be less than rock solid. Eventually, everything would become suspect, and gold and precious metals would shoot through the roof.

This would cause a huge spike in interest rates, causing stock prices to collapse, and, worst of all, would critically damage investor confidence. Since all investment markets rely on confidence, this could produce a panic as severe, or worse, than the panic that seized Wall Street in October of 2008. Worse than that, there would be no U.S. Federal Reserve to save the markets from themselves. They wouldn’t have any money with which to operate, and whereas the U.S. government was seen as the only possible savior in the Panic of 2008, it would be the cause of the problem this time. With no one left to act as “lender of last resort,” it’s entirely possible that financial markets around the world would collapse, possibly triggering a depression on the scale of the 1930s or worse. We really do not know how bad it would be – only that it would be unprecedented, and very, very scary.

But if the consequences are potentially so extreme, why are the markets not reflecting this? Let’s run over the potential counter-arguments.

“This is all just negotiating tactics. They won’t allow a default to happen.”

Perhaps so, but playing chicken while driving a truck full of nitroglycerine over rocky terrain doesn’t leave you much room for mistakes. Moreover, I’m not sure that the players involved are smart enough to understand the magnitude of the problem, and they could easily misjudge the situation. Even if they are planning to come to a last minute compromise, it’s not clear that the markets will wait that long. The rating agencies have already warned that if they don’t see a settlement by mid-July, they could downgrade U.S. securities, even without a default. Since a negotiating posture is only effective if you make the other side believe that you’re serious, the Republicans will have to act as if they are prepared to allow a default if they don’t get what they want. In so doing, they may also convince the rating agencies of the same thing, triggering the kind of run on Treasuries that I described above.

Moreover, the markets might get spooked before the rating agencies can act. The thing that scares investors most is uncertainty. If the biggest, most important financial entity in the world suddenly looks shaky, investors might suddenly decide that they need to run for the hills. Once a panic starts, it would be very difficult to stop.

“The U.S. government can’t possibly be this stupid. This is all show. It’ll blow over.”

Not true, and there’s precedent to prove it. On June 17^th, 1930, President Herbert Hoover signed the Smoot-Hawley Tariff Act of 1930 into law, raising tariffs on 20,000 imported items, and triggering a massive trade war that caused global trade to drop by two-thirds in a period of four years. Yet, Hoover had been warned by over 1,000 of America’s most eminent economists. He had been intensively lobbied by Henry Ford, who called the bill “economic stupidity.” The CEO of banking giant J.P. Morgan begged Hoover not to sign the bill – but he did, for political reasons.

Make no mistake, this is a very, very dangerous situation – a big, honkin’ Black Swan if there ever was one – that is comparable to the massive error of passing Smoot-Hawley. So don’t count on the government coming to its senses. History argues that governments sometimes do stupid things for ideological and political reasons.

“You’re exaggerating. The effects of a temporary halt in payments couldn’t possibly be this extreme.”

Who knows? This has never happened before. Once the U.S. government has failed to live up to its responsibilities for any reason, and for any period of time no matter how short, it will be impossible to regain the “full faith and credit” of a borrower that is beyond suspicion. Indeed, the rating agencies have a policy of automatically downgrading the ratings of a borrower that fails to live up to all of its obligations, if any investors lose money through delayed or halted payments of interest or principal. At time of writing, for instance, Standard & Poor’s has just warned that if Greece extends the payment schedule on its debts, as is being discussed within the EU as a possible solution to Greece’s debt problems, that would constitute a default and trigger a downgrade. And the rating agencies are still smarting from being accused (correctly) of not being tough enough on issuers in the asset-backed securities markets prior to 2008. They won’t want to be seen to be committing the same mistake again so soon, regardless of the consequences.

Perhaps I’m wrong, but as a former credit analyst, and one who used to assess sovereign credits for a living, I don’t believe I am. Moreover, those who pooh-pooh the consequences have no basis or evidence for their assertions. It is wishful thinking, pure and simple.

“This is nonsense. It can’t happen. They won’t let it. This just isn’t possible.”

Who’s “they”? This is just more wishful thinking, and is comparable to pulling the covers over your head to ward off danger while the house is on fire.

“You’re being irresponsible by talking about this. You’re going to create a panic by doing so.”

No, the irresponsible, brain-dead idiots at the extremes of the Republican party are running that risk. I’m just talking about the potential consequences of their actions. Besides, I’m not the first, nor am I the most important person to discuss it. The rating agencies have issued very forceful (for them) statements on this. The Chairman of the U.S. Federal Reserve, Ben Bernanke, has said this is dangerous folly (although not in those words). The International Monetary Fund has warned that this is an irresponsible and exceedingly dangerous path that could cause a “severe shock” to the American and global economies. The current Secretary of the Treasury, Tim Geithner, has said that it would be “catastrophic”, and even one of George W. Bush’s economic advisors, Keith Hennessey, has publicly said that he’s “terrified” at the prospect. I doubt if my comments will make much difference – except to my readers. For them, I hope it helps them prepare contingency plans in case the unthinkable happens.

“A default would actually be helpful, as it would force America’s government to face the reality of its financial position.”

Nope. As I’ve already said, it would trigger an absolute panic and bankrupt the government, which would then be forced to make long-term policy on the basis of emergency conditions. It would have to make bad choices, possibly even very bad choices, because better choices would no longer be available. Tackling the deficit is going to be tough. Trying to do it while simultaneously trying to keep the global financial markets and global economy from complete collapse would be impossible. This is just a bad idea.

“This is Obama’s fault. He’s the one that’s being unreasonable. We have to bring down the deficit, and this is the only way to force liberals to cut spending.”

Presidents and Congresses have disagreed about critical issues before, but no one has ever used the debt ceiling as a threat, and it is the Republican extremists that are doing so. This is on all fours with strapping a bomb to your chest, and threatening to blow everyone up if you don’t get exactly what you want. It’s no less threatening, and no less extreme than that, and it is Republican extremists that are doing it, which brings me to the political dimension of things.

I grew up in the Republican party. My father was a die-hard Republican, and I was raised that way. I voted that way when I first started voting. Since then, I’ve voted more discerningly and hopefully more thoughtfully for candidates that I thought were the best (or least-worst) choices, both Republican and Democrat. But this is not my father’s (or my) Republican party. The current Republican party seems to have been captured by fanatics who believe that ideological purity is more important than reality. They are spoiled children, throwing a tantrum to get what they want, and endangering us all in the process.

And those who have regularly read my blog know that I believe the U.S. budget deficit must be tackled, hard choices must be made, and sooner rather than later. But what the Republican extremists are demanding is that a process that should be thoughtfully devised, then carefully negotiated, and implemented over a period of years in order to minimize the necessary harm inflicted must, instead, be accomplished overnight, and that all the costs must be borne by someone else’s constituents, not theirs. Some of these extremists have even demanded tax cuts be part of the deal, even though such cuts would increase the deficit, not decrease it. They are clinging to an ideology as defunct as Soviet Communism, and pointing to the Reagan tax cuts as being self-financing, even though Reagan’s own budget director, David Stockman, has said that tax cuts in today’s environment would be a bad mistake. Indeed, in talking about extending the Bush tax cuts during the 2010 debate, Mr. Stockman said that the Republican position was “Utterly disingenuous. I find it unconscionable that the Republican leadership faced with a 1.5 trillion deficit could possibly believe that good public policy is to maintain tax cuts for the top 2 percent of the population”.

But extremists don’t want to hear that, and so they don’t listen. They have substituted ideology for thought or reason. They are ideologues as blind as any group of religious fanatics, except they could cause much greater harm to a much larger group of people, both at home and abroad.

“Forcing the government into default is the best way to make sure we’ll beat Obama in 2012.”

I haven’t actually read any reports where someone has said this, but some Republicans seem to be thinking it awfully loudly. If I’m right in thinking this, then it is a morally bankrupt attitude, verging on treason. It amounts to saying that you are willing to crash the American economy, trigger a collapse of the world banking system, and bankrupt many American citizens for selfish political gain. It would be like deliberately losing a war in order to win the presidency.

“So, what should we do about it? If the situation is as bad as you say, what’s the answer?”

Now we come to the reason for this blog: to offer some thoughts about what individuals should do to prepare for this possible black swan event.

The first thing to do is to hope that the participants are more intelligent than I give them credit for, and resolve this issue quickly, before they spook the markets or the rating agencies. If they wait too long, it may be too late, so August 2^nd (or sometime that week) may be the outside deadline; the markets might panic before than. And writing to your Congresscritter wouldn’t hurt. Tell them that Congress & the president need to come up with a credible plan for reducing the deficit through painful spending cuts, tax increases, and especially through reductions to Social Security & Medicare entitlements, but that not raising the debt ceiling is not a legitimate negotiating tactic.

Next, watch the news for developments. Assuming that we can’t influence the participants (and they seem impervious to argument no matter who offers it), then you need to prepare yourself for the worst. You needn’t do it all at once, but make sure you stay ahead of the market’s perception of a crisis. And this is where systematic risk management comes into play.

In this situation, we are running two opposing kinds of risk: the risk that there will be a panic, market collapse, and massive recession or depression; and the risk that the U.S. won’t default, that a crisis will be avoided, and the markets will continue to advance. Let me deal with the second risk first.

If a crisis is averted, and the world carries on with business as usual (which is what I devoutly hope will happen), then the market will carry on as if nothing important happened. As the stock market has been rising of late, it’s possible that if you sold holdings in advance of a possible crisis, you could forego potential capital gains by liquidating your holdings. This is a potential opportunity cost, but not a large risk. Suppose the S&P 500 were to regain its previous 2008 high before you could manage to buy back into the market. This means it would have to run up by about 16% in a very short period of time. So, on the extreme high end of things, the second risk is that you might forego about a 16% gain from where we are today – and that’s assuming that the market keeps going up, and actually goes up much faster than it has of late. I think this is highly unlikely, but let’s leave it at that: the risk of missing an upside move by the markets is foregoing a 16% increase in your portfolio.

The Default Risk

Now let’s consider the first risk: that, intentionally or not, by August 2^nd or somewhat before or after, the U.S. government defaults on its obligations, and that triggers a panic. What would be the financial risk if you don’t prepare for that possibility?

Well, first, how far might the market fall? In the market panic of 2008, the S&P 500 fell more about 54% from its October 4^th high. The stock market crash of 1929 was slightly worse, with the Dow Jones Industrial Index (“DJII”) falling on the order of 58%.

But the initial market crash of 1929 is not the biggest risk; the potential for a prolonged severe recession or depression is. Indeed, the stock market decline from 1930 to 1932 was actually worse than the crash of 1929, with the DJII falling 79% from the market low of 1929 to the market bottom in 1932. All told, from the 1929 high to the 1932 low, the DJII lost an incredible 89% in value. And that is, in my opinion, the comparable risk investors run from a potential default, aside from any economic damage they might incur, such as losing their income or their home.

So, now we come to the issue of risk assessment: Which is the greater risk? Missing out on a potential 16% investment gain from here, or losing 89% of the value of your current portfolio from here, plus experiencing significant economic suffering? Remember that the markets are largely ignoring the closed-door discussions on raising the debt ceiling, so that if a deal is announced, it is unlikely that the stock market will blast off to that 16% gain in a short period of time, whereas if a default occurs, everyone will thunder for the exits at the same time. In my mind, there is no comparison: it is far riskier to ignore the potential for a default than it is to forego the potential for gain.

So What Actions Should You Take to Prepare?

If you concur with my assessment, what do you sell, what do you buy, and how do you prepare? I’d start by selling investments that have done well for you, but may have limited upside from here. You can always reinvest later if the crisis passes. If the days tick by, and there is still no word of settlement, I’d start selling more earnestly, including things that perhaps you don’t feel have done as well as they should. Remember that the rating agencies have warned that they are expecting to see a settlement by the middle of July. If no such signals emerge, they may start being more vocal, and the markets may become more unsettled.

If, by the third week of July, there is no sign of a settlement, and the two sides continue to say they are deadlocked, it’s time to take serious defensive action. Sell any investment that is not a disaster scenario holding. Perhaps even sell money market funds to hold cash. And check the terms and conditions on your financial accounts. Following the banking crisis of the Great Depression, financial institutions added clauses that give them the option to require 3-5 day’s notice of a withdrawal. Just because they have waived that requirement for almost 80 years doesn’t mean that it’s not there, so check with your banker or broker.

In the extreme, if it seems likely that a disaster is going to happen, think about what you think will hold its value. This starts with gold & precious metals, but also think about how you want to hold it. If you have investments in a mutual fund that invests in precious metals, and the company that runs that fund goes bankrupt, what will the value of your holding be? Cash is likely to be worth having, or being able to get hold of quickly – but who’s cash? Do you want US dollars? And always keep in mind safety. Do you really want to have bunches of cash under your mattress? What about the risk of fire or theft? How do you want to deal with that? These are issues that deserve some serious consideration.

And if a deal is struck “at the last minute” (whenever that might be), and there is no default, and no run on the markets, then what? Then you take a long look at the risks as they are at that time, and, if you’re convinced that the risks are now on the upside (i.e., that you might lose more by missing a major market advance than remaining on defense), then unwind your defensive positions, and go back to your investments.

If I’m overreacting to the potential risks, and life goes on as usual instead, it will have cost you some money in transaction costs, and you might possibly forego some upside on your investments. If I’m correct in my assessment of the risks, then taking a defensive position may make the difference between financial survival or not.

And, for the record, I sincerely hope a deal is struck. I may wind up looking foolish, rather like Chicken Little screaming that the sky is falling, but I would prefer that result to the horrors of being proven right. If it’s a choice between pride and survival, I’ll pick survival. But I’d be prepared for either one.

© Copyright, IF Research, July 5th, 2011.

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