Debt ceiling – Economic Memo #35

When I was a kid my dad brought home a salamander which I adopted as a pet. Now I took care of the salamander well but salamanders are going to be salamanders and mine got out of it’s enclosure and into the food cabinet.

I tried to catch it but it was too fast and I finally gave up. Now you have to think about this catastrophe. What were the worst and best possible outcomes?  Should I tell my mother or let it go? Would the salamander eat all our food, poison it, or would there be no impact? What do you think I did?

Well, that’s not the question that we are asking about the defaulting on our debt. Defaulting has only one outcome, disaster! has listed the likely outcomes very well. I have added my comments in parenthesis and italic.

1. Depression and unemployment

Financial shockwaves, beginning at the Treasury and Federal Reserve, would make their way through banks and eventually blow a hole through the Main Street economy. Just as in the 2008 financial crisis, businesses would quit hiring amid the uncertainty. The unemployment rate would rise from its current 7.3 percent.

As an illustration, the jobless rate was 5.0 percent in December 2007, about where it had been for the previous 30 months, according to the Labor Department. By the time the Great Recession ended, it was at 9.5 percent, and peaked at 10.0 percent in October 2009.

A slew of other events would slam the economy: A drop in stock market prices, hurting many Americans’ 401(k) investments; the seizing up of bank lending; and the U.S. losing standing in the international marketplace. With U.S. economic growth still below 3 percent, it wouldn’t take that much to send the nation into a financial tailspin.

(Since September 19, 2013 the S&P 500 has dropped from 1733.14 to 1656.40 or 2.67%, the NASDAQ has dropped from 3789.38 to 3677.78 or 2.32% and the Dow Jones Industrials from 15536.55 to 14802.98 or 3.89%. In real terms this means every $100,000 an investor has in the market, they lost nearly $4000 on the Dow industrials. Are you likely to go on vacation, buy a new carpet, new washer, dryer or any other item? How many jobs are affected?

            That is the impact already, not the impact that will come from a default.)

2. Dollar down, prices and rates up.

Among the biggest impacts could be mass selling of the U.S. dollar, an event that would threaten the greenback’s standing as the world’s reserve currency.

(Internationally a country’s currency is’ backed’ by the amount of US or Euro’s they have in the bank to pay for the obligations. They use dollars because it is a stable economy and currency and the gold supply dried up with our use of trinkets. Of course, the Rand Paul and his TEA Party friends have suggested we go back the gold standard, which would eliminate monetary policy. Some of their idea’s simply don’t make any sense. Let’s go back to the dark ages and forget what we have learned.)

That would pound consumers’ buying power by boosting prices for everything from groceries to clothing to the gas we pump into our cars.

(We would have less buying power since it would take more dollars to buy the same number of goods.)

“In the event of an actual default, Treasury yields and other borrowing costs would probably rise and remain higher,” warned Julian Jessop, Capital’s chief global economist.

(There is no question, in my mind, this will happen!  I would point out that the last time the Tea Party threatened this, the bond rating agencies lowered the US bond evaluations because the politicians were not acting rationally. The Chinese though bought the debt and the interest did not rise. That was threat not the real thing. I don’t think even the Chinese who we owe a great deal of money to would appreciate us defaulting.)

So homeowners and prospective homeowners would have to say goodbye to the low mortgage rates they have enjoyed while the Federal Reserve has kept its foot on the economy’s gas pedal.

(Several weeks ago, the Chairman of the FED hinted they would take the foot off the gas and the markets fell significantly and he quickly had to revise his statement.)

“All the money you’re gonna have is under your pillow, and it probably won’t be worth as much as it is today,” Kyle Bass of Hayman Capital Management told CNBC’s Squawk on the Street. “But I don’t think we’re going to get to that apoplectic point in the U.S.”

 3. Down go your investments

Stocks have had a rough month. That raises worries for many Americans whose nest-eggs are held in company 401(k)s and other retirement accounts.

During the last financial crisis in 2008, major U.S. equity indexes tumbled, with the S&P 500 Index losing 37 percent for the year, which translated into big losses for many 401(k) retirement plan assets, according to the Employee Benefit Research Institute.

Just how individual 401(k) participants were affected by the downturn largely depended on the mix of assets in their funds. For example, investors with a high percentage of their 401(k) in stocks (versus bonds or cash) took a bigger hit than those with more balanced funds.

While many analysts have been trumpeting the market’s refusal to panic over the prospect of a default, that relatively sanguine reaction likely would change.

Estimates among Wall Street analysts are the market would drop between 10 percent and 20 percent — with the upper end at what Wall Street defines as a bear market.

(The truth is that I put a significant amount of my retirement money on the sidelines. The markets are going to increase rapidly, like today, on any morsel of good news, and die on no action. Frankly until the Tea Party is caged, there is a whole lot of risk. You may as well go to the casino. If you are not a risk taker, it is time to watch. You will be unhappy on the days it goes up and happy on the days it goes down, but you will be safe. It’s not the way it is supposed to work, of course. Once some adult reasoning comes back, it will be time to assess the damage already done and determine if the economy will continue forward.  Make no mistake about it, the economy has already been hurt by the actions of a few.)

4. Social Security payments halt

The current projection for the government to run out of money to pay its daily bills is Oct. 17. Economists believe, though, that the Treasury would have enough money on hand to pay its $12 billion Social Security payment due that day, as well as another one on Oct. 25.

That may not be the case come Nov. 1, though, when there’s a $25 billion payment due, meaning that checks may not get issued past that date.

Nov. 15 stands as a larger date overall when the Treasury won’t be able to make a $30 billion debt payment.

“We strongly suspect the current impasse over spending and the debt ceiling will have been resolved well before then,” Capital Economics said in a report. “There is also a chance if the shutdown was still in effect at that point then the Treasury, perhaps with the Federal Reserve’s help, would be able to avoid a default somehow. But in a worst case scenario, this is the date to watch.”

(The average social security check is $1000 a month and for 40% of the recipients this is their only source of income. The human impact of what is going on is very sad.)

5. Banking operations freeze up

One chilling data point: American banks own $1.85 trillion in various government-backed debt.

The effect, then, of a default on that debt would be devastating.

“If the Treasury and related securities were in default, one does not know what they would be worth,” Bove said. “Assume a Latin American valuation of 10 to 20 cents on the dollar and an estimated $1.28 trillion in U.S. banking equity would be wiped out.”

(Banking analyst Dick Bove, at Rafferty Capital Markets)

The potential result?

“It is my strong belief that a true default by the United States Treasury would wipe out bank equity,” he said. “All bank lending to the private sector in the United States would stop, immediately. Existing loans would not be rolled over. Immediate repayment would be demanded.”

(I can’t add to that!)

6. Money market funds break

The $2.7 trillion money market industry operates on a basic premise: Millions of American depositors won’t lose money.

That agreement broke briefly, with one fund, during the 2008 financial crisis, to destructive effect on investor confidence. It could happen again in the event of a default.

A recent Federal Reserve study said the damage during the crisis eventually could have involved 28 funds that would have “broken the buck.” Bove said a default would hit “virtually every money market fund in the country.”

“At present, (money market funds) that do not actually earn enough money to pay back 100 cents on the dollar are subsidized by the fund management company,” Bove said. “A Treasury default would make this virtually impossible and millions of Americans would lose billions of dollars.”

7. Global markets walloped

Some of our biggest trading partners are equally rattled by the prospect of the U.S. defaulting on its debt. The International Monetary Fund this week warned that a default would push the U.S. economy back into recession and cause “major disruptions” for global markets.

Meanwhile, China and Japan — the largest foreign holders of U.S. Treasury debt — have stepped up calls for quick action. China and Japan held $1.28 trillion and $1.14 trillion in U.S. Treasury securities, respectively, as of July 2013, according to U.S. government data. A fall in U.S. government bond prices would deplete the value of their reserves.

(Who would have thought the Chinese and Japanese would be the biggest stakeholders in US economy 60 years ago.)

Saber-rattling by China and other foreign investors aside, there is little actual chance the governments who own America’s debt would actually sell it. To do so would cause a panic that would make their investments worthless — the diplomatic equivalent of cutting off their nose to spite their face. That said, investors might see a dip in the value of their international funds.

(Let me point out in my defense before all my Republican and Tea Party friends start sending me emails. I give more money to Republicans than Democrats. I have to admit recently I am not giving to anybody, I think the 5% congressional approval rating is right on.

Also my comments are completely based on my experience as an economist and meant to only be relevant to that area. )

(My point is a very simple one. Assume the US economy is a giant Aircraft carrier and the House, Senate, and President steer the ship toward some goal or port. If the Republican House can’t determine where the economic ship it headed, we have a massive problem, which could result in the defaulting on our debts. The Tea Party conservatives have openly set their goal as defunding Obamacare and it would appear that horse is long gone. While the discussion of what to do next goes on we all suffer economically. )


(So there you have it! It is not a pretty picture. Call your congressman.)

About Larry Hill

Dr. Larry Hill is Chair and Professor of Economics. Areas of interest include economic analysis, energy economics cost benefit analysis and economy. To subscribe to the email list of Dr. Larry Hill's Economic Memos, contact Tracey O'Brien at Credentials include 1967 B.S., Indiana State University, 1968 M.S., Indiana State University, 1976 Ph.D., Northern Illinois University He is a member of honorary fraternities in economics and social science. He is currently writing a book on Managerial Economics and revising previous book, "The Basic Macroeconomics of the American Economy"

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