Why Debt and Debt Ceilings Matter

Déjà' Vu all over again...

It was just last May that I was writing about the PIIGS (Portugal, Ireland, Italy, Greece, & Spain) and how they could impact markets. Well a year later, the ripple in the pond that is Greece has clearly made and continues to impact markets in the US and around the globe. As the inevitable default of Greek government debt moves nearer, (regardless of how Euro-Zone policy makers spin it when any borrower owes 50% more than their revenues/GDP, some of their lenders, bondholders, creditors, and retirees will be paid late and some will not be paid at all) on Friday July 8th a big sell off occurred globally when market eyes turned to the second "I" in PIIGS; ITALY. 

Recall that my position was and continues to be that the relevance of Greeceis not the country in and of itself (as it is still roughly 2% of the total Euro-zone economy). Rather, it is how do policy makers, citizens, and corporations honestly and effectively deal with a country that is aging and slowing in population growth, with debt as far as the eye can see, slowing or negative economic growth, high or rising unemployment...and unable or willing to simply tax or print money to escape this quagmire? 

Now, if Greece which ranks 32nd in world economies and its debt issues are this destabilizing to the entire Euro-zone, (threatening in some minds the ongoing existence of the European Union) and roiling global financial markets, then what of Italy, the world's 8th largest economy, Spain the 12th largest with a 21% unemployment rate? 1 Or let's ponder... 

What could a U.S. default mean? According to Treasury Secretary Timothy Geithner, were August 2nd to pass without the extension of the U.S. government's ability to borrow (aka raising the Debt Ceiling), this inaction and Geithner's subsequent decisions would have a significant global impact. Back on May 16th to prevent this from happening, the Treasury Department took "extraordinary measures", in Geithner's own words, to avoid default. Those measures included suspension of Treasury payments to the Civil Service Retirement and Disability Fund and the Federal Employees' Retirement System Thrift Savings Plan.2   Meaning, the government stopped paying into the pension and disability plans and 401k type retirement plans of its current workforce as otherwise the government was out of money. 

As the Secretary explained in a letter to Senate Majority Leader Harry Reid (D-NV), a default would mean that "the Treasury would be prevented by law from borrowing in order to pay obligations the Nation is legally required to pay, an event that has no precedent in American history." A default would limit, halt or impact Social Security and unemployment benefits, veterans' benefits, federal worker salaries and payments to members of the armed forces.3 

Probably the first thing Geithner would do is pay off bond investors (you know China, UK, Japan, corporations, and all us savings bonds holders), thus a formal default wouldn't occur. However, after all of these investors are satisfied, then the Treasury's real juggling act begins. As Secretary Geithner would still have to delay or not make millions of payments to Social Security recipients, federal employees, private contractors and even soldiers. For the record, the U.S. government makes about 80 million check payments (including electronic) every month.2 

Technically, Americawouldn't actually default on August 2nd by delaying some federal payments, the way debtors who are in over their head have to juggle bills. The difference is that the postponement of federal payments would have a dramatic impact on businesses cash flow, consumer spending, consumer credit, interest rates and for many, monthly living.4 

For the skeptics (and based on the performance of policy makers in the last half century, cynicism and pessimism are understandable), worst case visualize something on the order of the Wall Street downturn of 2008-2009 happening again, in an even broader context. 

America sells Treasuries to finance its federal government operations and other nations, and investors have bought them with absolute confidence - the U.S.has not defaulted since 1933. A default would elevate borrowing costs across the board acting like a massive tax. Higher interest rates would be demanded by all treasury buyers for taking the "risk" of buying U.S.debt, along with implicit damage to stock prices and home values.4 

Credit Agencies Warn Policy Makers. Last month S&P, the credit rating agency said it will cut the U.S. debt rating from AAA all the way to D if the debt cap isn't increased by the August deadline.  Moody's has indicated it would cut the U.S. rating to somewhere in the AA range, which is three steps beneath its highest ranking.5 

On Bloomberg Television, S&P sovereign rating committee chairman, John Chambers warned that a U.S.default would rock global markets in a way that would be "much more chaotic" than the shock from the 2008 Lehman Brothers bankruptcy. Fitch, another credit rating agency is less gloomy; on June 21st, it characterized the U.S. as "very likely" to raise its debt ceiling before the deadline looms.5 

What Can We Do? It is probably easier to predict the stock market accurately then it is to guess what's next from most politicians, particularly when they are posturing in advance of a competitive election. As we are all members of an interconnected global market, chaos in any part of the system will inevitably create some "buying" opportunities for long term benefit in some areas; while also leaving misfortune in others. Risk, credit risk, and liquidity risk are the some key areas for investors to examine and discuss. 

Most importantly for allU.S.citizens, a default would shatter the confidence other nations have in the political framework. Which is paramount, as theU.S.currency since 1972 is not based in gold, rather it is backed by the FULL FAITH AND CREDIT of THE GOVERNMENT of THE UNITED STATES. It could be decades before theU.S.could restore confidence and count on cheap debt again should a default occur. 

Citations 

1- siteresources.worldbank.org/DATASTATISTICS/Resources/GDP.pdf [7/1/11]

2- Treasury Department

3 - treasury.gov/connect/blog/Pages/letter.aspx [1/6/11]  

4 - economix.blogs.nytimes.com/2011/01/04/fearing-another-u-s-debt-default/ [4/1/11]     

5 - bloomberg.com/news/2011-06-29/moody-s-would-likely-cut-