Thursday, July 28, 2011

What Happens if the U.S. goes into default?

Some people think that this is going to be like when the federal government shutdown in 1994.  For those who remember it, it meant things like national parks were closed, several agencies were shutdown, and many federal workers got an unpaid layoff.  While those things had a negative impact on the economy, a failure to raise the debt will be disastrous in comparison.

Why this will be different all comes down to the two different kinds of government spending.  Mandatory and Discretionary.  Mandatory spending are things that get automatically spent based on current rules.  For instance, when you're 65, you get social security.  Congress doesn't have to pass a special law for that to occur.  Discretionary spending is programs and agencies that must be renewed every year.  For instance, the commerce department only gets a budget to hire so many people every year.  During a shutdown over the federal budget it's employees go home, but any bills it already agreed to pay are honored.  Same with Social Security.  People who work for Social Security during a budget showdown will be sent home, but the people on Social Security will continue getting their checks in the mail.  This is not true over a problem with the debt limit.

With the debt limit, once it's reached, no new government checks will be issued.  So everything that happens during the 1994 shutdown will happen plus more.  States and local governments won't be re-imbursed for education expenses.  Social Security payments will be missed.  People won't be able to exchange their U.S. bonds for cash.  Now you can start to see why this is going to be so bad.  States and local governments will be hurt, retirement plans that depend on U.S. treasuries will be hurt, doctors won't get reimbursed for their medicare patients, and worse anyone who depends on social security just to scrape by will be devastated.  All of the things that the federal government has already committed to paying for (via law) will now go unpaid for.

So is the U.S government going to default?  Even though all limits on the Federal Government's finances is self-imposed, it is still possible to volunaterly default.  So, Whether or not there will be a default, is entirely a political, not financial question.  Not raising the so-called debt limit is one of the ways to voluntarily default.  Unfortunately, the geniuses in Washington may be about to do that for the first time in the history of our country.  My guess is that the chances of a voluntary default seem about 50-50.

So what should we expect and what should be done in preparation for a default?  I would expect that most of the federal government will shutdown.  Officially, people and departments will still be "in business", but it won't be able to pay its employees or contractors so they'll all have to be sent home.  This poses a problem for those in the armed forces.  My guess is that if you're in the armed forces you won't get sent home nor get payed for a while.  However, when the deficit limit is raised, you will get your full back pay.  In fact, I'm pretty sure that goes for any government assistance to states, cities, or people.  You're going to go without pay for a while, but the politicians raise the debt limit, all back pay will be honored.  The reason is that, by law, these groups are owed this money.  I'm not a lawyer, but I'm pretty sure that means the back pay will have to be redeemed.  However, I wouldn't hold out hope for getting payed interest for the late payments.

As unprecedented as a voluntary default is, I think most of what's going to happen is fairly predictable:  Most government workers will be sent home without pay and there will be a delay in sending out government checks.  The only wild card is what's going to happen to the bond market?  U.S. treasury securities have always been a no-brain safe investment.
If banks and investors can no longer turn in those due U.S. securities, what's going to happen?  First of all, I am 99% sure that those bonds will eventually be honored once the debt limit is raised.  In the meantime, what's going to happen.  I am not certain.  A lot in the media think that it means that interest rates on everything is going to go up.  But, these are the same people that think the federal government can run out of money.  So, I'm not going to just take their word for it.  The theory is that the U.S. bond market sets the overnight interest rate.  Banks (for the most part) set their long term interest rates on how cheaply they can get more money to lend today.  Therefore if the interest rate for long term bonds goes up, then all interest rates rise.

There's a couple problems I have with this.  First, it assumes that interest rates on U.S. bonds are going to rise.  I'm not entirely convinced of that yet.  First of all, the Federal Reserve can still flood the market with cash by buying U.S. treasuries as they have been.  Second, if the government guarantees that all bonds will eventually be honored, there's no reason to believe that the overall price is going to go up.

On the other hand, maybe interest rates will rise.  I've learned to never underestimate the irrationality of the financial markets.  Also, if the credit rating agencies like Moody's and the S&P actually downgrade U.S. bonds (another irrational move, if you ask me), there could be a rash of sell offs as pension plans and etc have to sell them off because they are required to have a certain amount of highly rated bonds.  If that happens, that's going to flood the market with U.S. bonds making them worth less and sellers would have to offer a higher interest rate to sell them - which then increases the interest rate.

My bottom line prediction for the U.S. bonds is that default will temporarily raise interest rates, but they will quickly fall again once the whole debt limit is settled.  How hi they rise will depend on the Fed's action as well as if the credit rating agencies officially downgrade U.S. bonds.

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