Some Insane Thoughts on the US Debt

On August 2, 2011 the United States will reach its maximum allowable debt level. When that happens, the US Treasury will no longer be able to fund the budget deficit and the United States government will technically be in default. The rating agencies will have to downgrade US Treasuries from their current AAA rating. Their bond prices will fall and the yields will rise. 

Congress, Senate and the White House are trying to put together a budget that will allow for the debt ceiling to be raised above its current $14.3 trillion limit. The Democrats don’t want any cuts to social programs. The Republicans don’t want any new taxes. The White House wants a deal that stretches to 2013 – after the next Presidential election in 2012. No one seems to be willing to compromise and the rhetoric is flying in all directions. 

A lesson in fiscal policy: to reduce a budget deficit, a government must raise taxes, reduce spending or both. The military is a non-starter as are subsidies to the energy and agricultural sector. The bailouts of Detroit and Wall Street are not to be questioned. Medicare, Medicaid, Social Security and pensions are vote killers. The astute reader will start to see the magnitude of the problem. 

Markets have been reacting by selling the US dollar, not by selling off Treasuries. As the US dollar falls, gold, the Canadian dollar, yen and Sterling all increase in comparison. (The euro has its own problems) 

Any rational person would think that this problem needs to be fixed and fixed fast. Politicians in Washington, however, don’t appear to be behaving rationally. But what if it is all a carefully orchestrated symphony of economic warfare? 

What will happen if politicians don’t reach an agreement? The rating agencies downgrade the debt and bond prices fall. The balance sheets of financial institutions take a hit due to the loss on Treasuries. To prevent the credit markets from drying up due to insufficient bank capital, the Fed institutes QE3, providing financial institutions with liquidity. The liquidity is used to purchase more government debt at reduced prices. The sellers of US debt receive US dollars which are then sold into the foreign exchange market depressing the value of the US dollar and causing an increase in the price of gold. Who is selling the gold in exchange for US dollars? Perhaps the US government and the profit on gold sales pays off some of the bonds.

After a period of adjustment, bond prices recover, gold falls and the US dollar rebounds. The US government buys gold off the market to replenish their reserves. (Buy low, sell high – not necessarily in that order) The financial institutions repay the Fed with the treasuries they have accumulated ending up with stronger balance sheets than they started with. 

So who loses in this scenario? Ask who is the largest external holder of US Treasuries and you will have your answer. The major flaw in all this is that the politicians have to be involved and agree to the plan and the secrecy, which we find highly unlikely. If we throw in a murder and a love interest for the economist that uncovers the plot, we have a pretty good Stephen Frey novel though.

The US Debt Debaucle

I would love to interupt my vacation in Florida to do an entire series of articles on the US Debt situation, but the sun is shining and I am feeling "disinclined" as Capt. Barbossa would say. There are enough news articles floating around.

To summarize the issue, the US Congress has imposed an upper limit on the amount of debt that can be issued by the US treasury. The ceiling will be reached early in August. To reduce the amount of borrowing, the government must reduce the size of the deficit. This requires an increase in taxes, a decrease in spending, or both. The Tea Party wing of the Republicans has vowed not to raise any taxes. The Democrats don't want to cut spending on social programs. Hence the stalemate.

The 14th Ammendment to the US Constitution tends to imply that the US Government cannot default on its debts which brings into question whether or not the debt ceiling limit is constitutional or not. President Obama sounds like he believes the 14th supercedes the ceiling. The US Supreme Court will have to decide at some point.

Moody's has threatened to downgrade US debt if they default in August. That would cause an increase in US interest rates and a drop in treasury prices. Banks holding treasuries would have to write down their holdings which, once again, would cause them to fall below the capital adequacy requirements. Enter QE3.

One issue that I have not seen, and am not entirely sure about (since palm trees are more interesting) is what happens to corporate debt ratings in the event of a downgrade of US government debt. In the mid 1990's when Canada's debt rating was downgraded due to the debt-to-GDP ratio, the bond ratings of all major banks was also downgraded. I recall the reason being that no private corporation in a country can have a higher credit rating than the sovereign debt rating. I reiterate that I don't know if that is still true, but if it is, the backers of certain Republican lawmakers may see an increase in their borrowing costs and a coincidental drop in their bond and stock prices if the Congress can't overcome this impasse.