12/27/12 - Back to DEFCON 1?

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Dec 27, 2012 5:50:28 AM

and tagged Fiscal Cliff, Politics and the Economy

Leave a comment

Back in 2011, during the last debt ceiling debate, the U.S. went into what could reasonably be described as potential default territory. We are nowhere near as close to that as we were then, but we are starting the downward slide, with Treasury Secretary Tim Geithner quoted over the weekend as saying that we will hit the federal borrowing limit on Monday (i.e., New Year’s Eve), which is to say in a couple days.

At that point, the Treasury will start to take certain “emergency” measures—I put that in quotation marks because we were here in 2012, and the only emergency is Congress’s unwillingness to act—which will allow the government to pay its bills for a limited time, probably a couple months, and avoid a full-blown debt crisis for that period. Timing is uncertain because it depends largely on the tax and spending agreements reached with respect to the fiscal cliff. How much money is raised and spent will be critical in determining how long the Treasury can juggle bill payments. We won’t know that until—and if—Congress acts on the fiscal cliff.

I have said multiple times here that, although the fiscal cliff can do real damage, the biggest potential problem is the federal debt ceiling. And here we are. Should Congress be unable to reach an agreement to raise the debt ceiling, the prospect of an actual default on the debt would loom, which would be a real crisis. We are months away from that, but we will be hearing quite a bit more about it in the coming weeks, and so I wanted to review exactly what might happen.

There are several levels that we must pass through on the way to actual default—and each could have dramatically different consequences. Let’s call these scenarios DEFCON (default condition) 1, 2, and 3.

DEFCON 1 explains where we will be come Monday, when we hit the borrowing limit. At that time, the Treasury will start paying bills using cash on hand and tax receipts, as well as by dipping into federal employee pension funds. What that means is, as of next Monday, we go into emergency mode and start spending down our cushion. Negotiations about raising the limit then acquire a new urgency, as there is a real deadline pending, even if we can’t tell exactly when it might be.

What will change if the government fails to reach an agreement by the deadline when the Treasury’s tricks run out?

DEFCON 2 is the next step. So far, even though we have reached the debt limit, we have been able to pay all outstanding obligations as they come due through the methods described above. The deadline will be when we can no longer pay these obligations in full, so something will have to give. One possible scenario in this case would be to prioritize the following payments:

  • Debt interest (a relatively small part of total obligations)
  • Social security benefits
  • National defense

After that, we could expect a shutdown of various parts of the government, again based on priority. As a guideline to what might happen, we can look back to the 1995/1996 federal government shutdown, when President Clinton and Congress could not agree on a budget.

If this occurs, the government will begin defaulting on its obligations in some sense; however, as long as bondholders continue to receive interest payments and existing debt can be rolled over, there would be no effective default on debt.

How long this scenario could continue is something of an open question, as it would depend on the timing of cash flows and obligations. If the cash flows could not support payment of debt obligations, we would move on to the next step.

DEFCON 3 is a full-blown default, where the government makes a political decision to not pay interest or principal to debt holders.This is the big one—and it is the apocalyptic consequences of this definition of default that most commentators focus on. Should we reach this stage, the global consequences could be dramatic. But because of the potential repercussions and the latitude granted by both DEFCON 1 and DEFCON 2, the chances of us reaching this last stage are relatively slim.

Back in 2011, although some media commentators assumed that “default” meant we would immediately arrive at DEFCON 3, many others refused to consider the possibility, believing that no “sane” politician would be willing to risk such far-reaching consequences. In effect, of course, they were right, and a deal was cut that avoided default. Hopefully, we will see the same assertion of sanity this time.

So what happens now?
We are currently heading into DEFCON 1, which will buy us at least a couple months before we even have to consider DEFCON 2. The consequences of reaching DEFCON 1 should not actually be all that serious, based on the 2011 experience, but again per 2011, as time passes, there’s no telling how the markets will react. Treasury rates have not spiked so far, which is a sign that the market does not anticipate anything beyond DEFCON 1.

As we have seen repeatedly, it’s important to separate the political theater from the actual economic situation. As with the fiscal cliff, there are enormous incentives to reach a deal. There are also enormous incentives to hang tough until there’s no choice but to sign an agreement—which means we probably shouldn’t expect a deal until the 11th hour.

Current proposals from the Democrats have attempted to wrap the debt ceiling into the budget talks, something the Republicans have resisted. Although a long-term deal responsibly balancing tax increases and spending cuts would make a debt ceiling deal easy in theory, it seems increasingly unlikely in the short and medium term. Any short-term deal to extend the Bush era tax cuts or mitigate federal spending cuts would actually make the debt ceiling negotiations more urgent, as the cushion would erode faster with less money coming in and more going out. Conversely, going over the fiscal cliff might actually extend the cushion period, as tax receipts would rise and spending would decrease.

We can’t know at this point how Congress and the White House will act, and these matters are entirely in their hands. Although there is no need to panic, the stakes have just been raised in the ongoing game of political and economic poker being played in Washington, DC.

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®