Worst Case Scenario: Not Raising The Debt Ceiling

A few weeks ago I asked if Anything Was Really Unexpected? One of my philosophies from that article was really thinking about possible worst case scenarios. One of the biggest uncertainties that is currently rattling the stock market and economy is the US Congress’s failure to address the debt ceiling.

So, what would happen if Congress failed to act, or act in time, to prevent the US from defaulting, or even if it doesn’t default, its reputation as a financially responsible country being tarnished? What does it mean for Wall Street and Main Street? Here are my thoughts…

 

How We Got This Far

The current debt ceiling is at $14.294 trillion. On May 16, 2011, this ceiling was effectively reached by the Treasury. That was almost 30 days ago, and we still haven’t resolved the debt ceiling issue. Right now, Treasury Secretary Geithner has been using a variety of stop-gap measures to meet Federal obligations. These measures include using federal employee payroll deductions to fund government obligations (instead of paying their retirement funds). Think of it like your current employer taking your 401(k) contribution to pay for current operations instead of depositing it into your account.

So, how did we get here? The last year there was a surplus was 2001. From 2001 to 2009, spending increased by 6.5% of GDP, while tax revenue declined by 4.7% of GDP.

What were the biggest spending drivers (as a percent of GDP):

1. Medicare (1.7%)
2. Defense (1.6%)
3. Unemployment Benefits (1.4%)

What were the biggest drivers of tax revenue reduction:

1. Individual Income Taxes (-3.3%)
2. Payroll Taxes (-0.5%)
3. Corporate Income Taxes (-0.5%)

So, basically we are spending more and taking in less income. Each half of that equation has been each parties argument in the debt ceiling debate: Republicans don’t want to vote on the debt ceiling unless it includes spending cuts, and Democrats don’t want to discuss the issue unless there are tax increases. Heaven forbid they compromise!

If these sides don’t get their act together quick, the Treasury Secretary will be forced to make so harrowing choices. The US won’t technically default unless it fails to pay its bond interest, which it can do, but it would most likely stop paying everything else (especially since income and spending doesn’t always line up daily).

However, this action alone would most likely panic the world. Here is what could happen.

 

What Would Happen If The US Stops Paying Everything But Interest?

If we get to a point where the debt ceiling isn’t raise, and the Treasury is forced to make tough choices, there may be some comfort knowing that default hasn’t technically occurred yet. However, the resulting shock to the financial system, even if we don’t default, would likely throw the entire world into a depression that would be far worse than anything ever seen before. I don’t mean to scare people, but the entire US economy is based on “The Faith and Credit of The United States Government”. And, most countries in the world rely on the US for trade, deposits, and many other financial functions. Thus, even if default doesn’t actually occur, the ramifications of potential default could be just as bad. Look at Greece and Portugal, who haven’t defaulted but have still been fighting a fiscal crises for months.

When word of Geithner’s action hit the market, all of the credit bureaus (S&P, Moody’s, etc.) would be forced to downgrade U.S. debt. This would send the financial markets into a panic. The stock markets would most likely see sell-offs of 20% or more in minutes, and the SEC would most likely halt trading.

The world credit markets would instantly freeze. Finance and insurance companies would need to verify their total liabilities, to both each other and what their potential exposure to US debt would be. Many long-term derivative contracts are based on credit ratings, and they would have to be re-valued. Many financial firms would be forced to write-down huge contracts, and may be short on capital requirements. If the stock market ever did re-open, more chaos would ensue with massive sell-offs.

US Bond prices would fall instantly. Financial firms, governments, and individuals would all be in a massive rush to sell off Treasury holdings. The market would most likely become so saturated to quickly that shorter-term securities would be rendered worthless. Longer-term securities would be trading for pennies on the dollar. Most governments and firms would also seek to sell their dollars and buy in other currencies, such as the Euro, or even the Yen. The dollar would be in a free-fall, and the Federal Reserve would have no way to stop its decline. Remember pictures of Germany, when people had to bring wheelbarrows full of money to buy bread? Well, that could happen very easily.

Also, since most banks and money market funds invest in Treasury bonds to protect themselves, most money market funds would “break the buck” and be worthless. Banks would face huge runs. Think your FDIC insurance would protect your deposit? Unlikely, as the FDIC reserves would be depleted too quickly to pay depositors whose banks failed. The FDIC also couldn’t raise funds, since it is a quasi-government entity, thus no borrowing.

On Main Street, this would essentially mean that you couldn’t access you bank account, your ATM wouldn’t work, and your employer could have a hard time paying you since the credit market would be frozen (most employers use credit for payroll to make up any gaps between spending and revenue received).

 

What If Default Actually Occurred?

If the US actually defaulted on its obligations, it would mean worldwide disaster. As of January 2011, 47% of debt was held by foreigners. The International Bank of Settlements recently stated: “Foreign investors in U.S. dollar assets have seen big losses measured in dollars, and still bigger ones measured in their own currency. While unlikely, indeed highly improbable for public sector investors, a sudden rush for the exits cannot be ruled out completely.” Basically, as I mentioned above, everyone would be sellers of US debt, nobody would buy, and the debt would be worthless.

However, sovereign debt owners have another option at their disposal: war. Throughout history, many countries have gone to war over debts owed, or to gain money to pay debts. Most notably, the English and French have both waged wars for debts throughout the sixteenth and seventeenth centuries.

Would China really consider such a move? They do have the resources to wage such a campaign, and the US may not be able to withstand a prolonged war, since it would be unable to finance it. Also, morale may be severely compromised if paychecks aren’t coming home to the soldiers involved.

 

What Can I Do? What Will Happen?

So, what can an individual really do? The sad part is not too much. You can try to persuade your Congressman to get their act together.

You can also look overseas…

However, in the end, nothing can really save us if the US defaults. The entire global financial system is so entwined around the US. Should something catastrophic happen, it will be disastrous worldwide. It would most likely take years to put the pieces back together again.

 

What are your thoughts? What do you think could happen? Am I going overboard? Any plans to keep your money safe?