Presented by Rich Tegge
We’re entering the third week of the shutdown, only days away from the point at which the U.S. Treasury will run out of money to pay all obligations. As of Tuesday morning, October 15, the Senate is claiming that a shutdown/debt deal is near. Nevertheless, the clock is ticking. Where do we stand now, and what are the potential effects?
The government shutdown
You may have noticed that the government isn’t actually shut down. Large portions of it continue to function, including the military and other essential components. And social security payments continue to be made. It’s only the “nonessential” parts of the government that have been shut down.
Another way to look at this is to break down spending into the legally required, or mandatory, components, which include social security, interest on the debt, Medicare and Medicaid, and discretionary spending, which incorporates the military. Military spending is about 19 percent of the budget, while other discretionary spending is only about 17 percent. Because the military largely continues to operate, the actual shutdown affects about one-quarter, at most, of the government.
Given that, the effect of the shutdown is not catastrophic. Although there have been consequences—a slowdown in processing federally insured mortgages and loans, for example—the damage has been limited. Some experts estimate that the overall hit to the economy will be around 0.25 percent of gross domestic product per week, which is not insignificant but can be easily overcome.
The debt ceiling
The debt ceiling, however, is worth worrying about, and it is important to understand what the debt ceiling means. It can be defined as “the maximum amount that the U.S. government can legally borrow in the bond markets.”
The U.S. hit the debt ceiling, as defined above, back in May, with very little reaction from the public or the government. Since then, the Treasury has continued to pay out more than it takes in—as mandated by Congress—by continuing to borrow from internal government pools of cash, including federal worker retirement funds. Those funds will have to be repaid, but not to the bond market.
The debt ceiling crisis, which is set to hit in a couple of days, is therefore actually due to the exhaustion of those alternative pools of cash. The crisis will revolve around the Treasury’s inability to pay out more than it takes in. At that point, the Treasury won’t be able to pay all of the bills as they come due, and it will have to make some hard decisions. This is where the notion of default comes in. At that moment, some obligations—some spending that Congress has mandated—will not be made.
How this is handled, should it occur, will determine how much damage is done. An argument can be made that it should be easy for the Treasury to prioritize payments, so that, for example, interest on the debt and social security bills can be paid, while payments for other, less essential, items get postponed. Under this theory, the damage should be minimal.
The problem with this idea is threefold. First, the problem is legal: it’s unclear whether the Treasury has the authority to prioritize such payments. If so, who decides what gets paid? How are the decisions made? Second, the problem is practical. Millions of payments are made automatically every month, and it’s far from clear whether the software can prioritize payments—the situation has never come up before—and there’s no time to modify it to make that possible. Third, the problem is political. Payments will not necessarily match up with receipts, and, if money runs short, it may lead to a choice between paying either interest on the debt—to the Chinese, perhaps—or social security benefits, but not both. What politician would choose to pay the interest in that case?
Hitting the debt ceiling, therefore, may mean hard choices and, ultimately, may mean actually defaulting on the debt.
Even if prioritizing payments were possible, and even if we could continue to pay the interest on the debt with certainty, the economic effects could take us immediately back into recession. The required spending drop would cut about 4 percent off of the economy directly—and perhaps more than that, when indirect effects are considered. Because we are now growing at a rate of about 2.5 percent, the drop would take us back well below zero and into recession. The damage could be much greater than that associated with the sequestration spending cuts, which have done so much to slow growth this year. The debt ceiling crisis, regardless of whether it could be mitigated by prioritization, would certainly do real damage to the economy and the country as a whole.
What if we do default?
Although default is unlikely, the consequences if the U.S. were to actually do so would be severe:
- Interest rates would certainly rise (which we’re starting to see right now).
- The stock market would certainly fall.
- The contagion effects could quite possibly disable the entire financial system.
Many investment funds, for example, cannot legally hold defaulted securities, which could lead to waves of selling. Much of the financial system’s infrastructure is based on transactions that rely on Treasuries as security, and a forced unwind of such transactions could also break the system. At a minimum, we would see tremendous disruption around the globe, on top of the economic damage caused by the immediate drop in federal spending.
Again, though, the potential consequences depend on what you mean by “default.” The U.S. actually has defaulted once before, for technical reasons and on a very short-term basis, and the markets saw that event for what it was—and ignored it. A similar very short-term default might also get a pass. Much will also depend on how the ratings agencies treat any default. A U.S. debt downgrade to default status would force many holders of U.S. debt to sell it, and this would be a major factor in potentially bringing about a worst-case scenario. Fortunately, the ratings agencies are well aware of this and have been measured in their treatment of the U.S. rating—but that has its limits.
The way a default would actually play out is also an issue. What would probably happen is that the Treasury could pay bills as they came due from incoming revenue until a particularly big bill, probably either a debt interest payment or a social security payout, came due. At that point, hard choices would be necessary. This is another reason that October 17 is not the hard deadline. The earliest probable hard deadline is November 1, but that is uncertain.
Where we are now
At this point, we know the following:
- First, there will be some limited economic damage from the shutdown, even if the government were to reopen immediately. It’s not worth worrying about at this point, but, of course, the longer the shutdown the greater the damage.
- Second, while we do have a deadline pending, the real deadline is probably a week or two past what has been reported. The Treasury is also no doubt working on ways to mitigate the damage should we pass either or both deadlines.
- Third—and this is important to remember—we’ve been here before, in 2011. At that time, we came very close, just as we’re doing now, but did not, in fact, go over the edge. Speaker Boehner has indicated that he doesn’t plan to allow a default, as have most of the other participants in the circus.
Although the short-term effects are certainly nerve-wracking, the chances of an actual disaster are still fairly remote. To restate a point made earlier, this is an eminently solvable problem, which means it can and almost certainly will be solved. The theater we see between now and then is the price we pay for a democratic system, and, as annoying as it is, this type of theatrical debate has actually resulted in meaningful improvements in the U.S. economic structure in the past year.
Though it is expected that a deal will be cut before the deadline, it may be short term in nature, which means that we’ll be living with these negotiations in one form or another for the foreseeable future. The results, though, should be worth it.
The U.S. economic structure has improved, with the deficit significantly reduced. This was a result of the “fiscal cliff.” The discussions now under way in Washington have the potential to create the same kind of positive effect. And, even though the risks are real, they remain just that—risks, not realities—and should be treated as such.
With that said, we focus on creating balanced, diversified portfolios for your accounts, and this can be treated as just another shock that should be ridden out. U.S. obligations will eventually be paid, regardless of any short-term “default.” The U.S. economy has been growing, despite the burdens this year of tax increases and sequestration cuts, and it will be able to surmount the latest headwinds out of Washington. The rest of the world is in better economic shape than a year ago and continues to improve.
Finally, as noted above, the short-term pain will quite possibly result in long-term gain. Although we are certainly mindful of the short-term risks, they are relatively small in light of longer-term trends. In many ways, perhaps the greatest risk to your own investments is if you overreact. This, too, shall pass.
Rich Tegge is a financial advisor located at Wealth Strategy Group 300 South Front Street Marquette, MI 49855.
He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at (906) 228-3696 or at: firstname.lastname@example.org.
Authored by Brad McMillan, vice president, chief investment officer, at Commonwealth Financial Network.
© 2013 Commonwealth Financial Network®