10/14/13 – The Whole Thing, Explained

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 14, 2013 11:33:31 AM

and tagged Fiscal Cliff, Market Updates, Politics and the Economy

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Over the weekend, I traded e-mails with one of our advisors, who pointed out that I hadn’t yet done a complete explanation of the situation in Washington, DC. Sure, I’d touched on various aspects of it, but I hadn’t really looked at the thing as a whole. So here’s my take. Thanks, Alex, for the great idea!

The Big Picture

Let’s look at the situation right now. The government, or part of it at least, is shut down. Meanwhile, we have a pending cash crunch for the federal government. Financial markets, stock and bond, are reacting to each reported twist and turn in negotiations between the Republicans and the Democrats. Volatility seems assured, and we’re told that, if no agreement is reached, catastrophe is right around the corner.

Scary stuff, and deservedly so. Yet, although there are very real reasons for concern, a closer look reveals no cause for panic for the average person, at least right now.

First, let’s consider the actual problem. It’s not that the government is shut down; that’s a symptom. Nor is the problem the potential for a debt “default,” which is another symptom. (I’ll get to why I have “default” in quotation marks in a second.) The problem is the inability of the two parties to reach agreement. Both sides are holding the nation’s economic health hostage to their own policy priorities.

This is actually a very good thing. Since there’s absolutely no economic reason for any of the current problems, that means they can be solved, and that can happen before we have a real crisis. Since the problems can be solved, I expect they will be—probably at the very last minute. All of the major players in Washington are aware of the potential consequences, and many of them, driven by fear, are already starting to act.

That said, we’re currently entering the third week of the shutdown, only days away from the point at which the Treasury will run out of money to pay all obligations. The clock is ticking. Where do we stand now, and what are the potential effects?

The Government Shutdown

The government isn’t actually shut down, as you may have noticed. Large portions of it continue to function, including social security payments, the military, and other essential components. 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, and Medicare and Medicaid, and “discretionary” spending, which includes the military and pretty much everything else people think of when they think of the government. Military spending is about 19 percent of the budget, while other discretionary spending is only about 17 percent. Since the military largely continues to operate, the actual shutdown affects about a quarter, at most, of the government.

Given that, the effect of the shutdown is not catastrophic. While there have been consequences—a slowing of processing for federally insured mortgages and loans, for example—the damage is limited. I estimate the overall hit to the economy at around 0.25 percent of gross domestic product per week, which is not insignificant but can be easily overcome. This is a slow leak in the economy’s tires, not a blowout; once the shutdown ends, it will probably recover quickly. I’m not, therefore, very worried about the government shutdown.

The Debt Ceiling

The debt ceiling is worth worrying about, but first let’s be sure we understand what we’re talking about here. I define the debt ceiling as “the maximum amount that the U.S. government can legally borrow in the bond markets.” This is a bit different from what is commonly understood, but you’ll see why I define it this way in a moment.

Next, let’s define just what we mean when we talk about the debt ceiling as a pending crisis. What is commonly referred to as the “debt ceiling” is actually nothing of the sort. In fact, the U.S. hit the debt ceiling, as defined above, back in May, several months ago—to absolutely no 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. This is why I define the debt ceiling as I did above; the Treasury has continued to borrow, and those funds will have to be repaid, but not to the bond market.

The debt ceiling crisis, therefore, which is set to hit in a couple of days, is 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 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 Treasury has the authority to prioritize such payments. If so, who decides what gets paid? How is the decision 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, will mean hard choices and, ultimately, very probably will mean actually defaulting on the debt, but most likely it won’t be immediate. The real deadline is probably not this week but a couple of weeks from now. Make no mistake, though, we’re getting closer every day, and, if we did default, the consequences could be severe. More on that later.

Even if prioritizing payments were possible, and even if we could continue to pay the interest on the debt with certainty, we’d still be in trouble. The economic effects of dropping spending to match receipts would take us immediately back into recession. The required spending drop would cut about 4 percent off of the economy directly, and more than that when indirect effects are considered. Since we are now growing at a rate of about 2.5 percent, that would take us back well below zero—into recession, and probably a severe one. The damage would be much greater than that associated with the sequester 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, and 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 treated any default. A U.S. debt downgrade to default status would force many holders of U.S. debt to sell and 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 payment, 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 Right Now

At this point, we know the following:

  • First, there will be some limited amount of 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 more 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.

While the short–term effects are certainly nerve-wracking, the chances of an actual disaster are still fairly remote. To restate a point I 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.

Looking Forward

I expect a deal will be cut before the deadline, but it will be short-term in nature, which means we’ll be living with these negotiations in one form or another for the foreseeable future. The results, though, should be worth it.

I mentioned above that the U.S. economic structure has improved, with the deficit significantly reduced. This was a result of the “fiscal cliff” that caused us all so much angst at the end of last year. The discussions now under way in Washington have the potential to create the same kind of positive effect; the unfortunate fact that only a crisis seems to drive progress is something we are learning to live with. It shouldn’t be this way, but I will take any progress I can get. And though the risks are real, they remain just that—risks, not realities—and should be treated as such.

With that said, if you have a balanced, diversified portfolio in place, 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 the tax increase and sequester spending 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. While I’m very 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, will pass.

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