LOST and the Debit Ceiling

For all you LOST fans, think about the season they found the bunker. In the bunker, there was a computer system. And every so many hours, a code had to be plugged into the system. If not, they were told that the Island would explode, and take them all out. So they entered the code. But this raised a philosophical question: what would happen if they didn’t enter the code? Would the Island really explode? How risky is risk? Was this really a manipulative game? In one scene, they decide to dare the system by refusing to put in the code, and this scary countdown starts. And suddenly,the characters are fist fighting and trying to hold each other back. But someone breaks through and enters the code. Welcome to the debt ceiling debate. Mark my words, this will happen.

But for shits, what will happen if we don’t enter the code? The Tea Partiers will have us believe that nothing will happen. But what would be the benefit? Robert Rubin, the former treasury secretary, said it best. He said, “we don't know what will happen, but why would you want to find out?” Didn’t we learn anything from the brink of disaster in 2008? Why would you want to take bigger risks? Is it for the adrenaline rush?

The Debt Ceiling is an arbitrary number that limits the amount of money we can borrow to pay our bills. It was sent by our legislators in 1917 and has been changed numerous times. Between 2001 and 2008, it was increased 5 times. Any small business owner who was unable to get a short term bank loan to cover payroll back in 2008 will understand completely the situation the US Treasury now faces. I am sure you yourself have borrowed from your savings to cover your bills, and then put it back. Maybe you ask your friend to spot you $50 with the promise to pay back $55 in a week, etc. It’s no different for the Feds.

For our readers who may not fully understand the debt, please read The Debt Limit: History and Recent Increases by the Congressional Research Service. This explains nicely how the government creates both Public and Inter-government debt. The short version is that debt is issued is through the sale of government (i.e. Treasury) bonds of varying duration. The US government currently pays the lowest interest of anyone on these bonds because it is deemed so low risk. This will change if default happens. For lessons, see Argentina.

The amount of government debt and revenue is in constant flux. Money comes in, money goes out. This further complicates the Treasury’s job of balancing the government’s check book. Because of the flux, Treasury can’t know for sure when we will actually run out of money. What we do know is that we actually hit the legal debt ceiling May 16th. But the Treasury has been able to juggle money to make ends meet-largely through accounting gimmicks and borrowing from government accounts (like civil servants’ pension funds). The Treasury estimates that it will run out of wiggle room on Aug 2. This is why stalling, gaming, and procrastinating are so serious. We may go into default without meaning to.

So if the government defaults, what happens? We don’t really know, but history offers guidance. In past instances when we have approached this limit, the markets have sometimes responded by starting to charge a larger risk premium in order to lend money to the federal government. This tends to encourage speculation on US treasuries in ways similar to what just happened with the housing market. You will start to see nations take out insurance on US debt which is a way of betting against our ability to make our debt obligations. This will further deepen our troubles.

Historically there have been many defaults and banking crises. Since 1800 France has had 12 years of banking crises, Norway 16. We had our own in 1936. Germany has spent 16 years in default or restructuring since 1800. Most victims suffered after wars. In this way, we are no exception. Usually, when there is a default, 6 things can effectively address a crisis.
1) Get a higher GDP.
2) Lower interest rates on public debt.
3) Get a bail out- go to the IMF or hope a friend will help you.
4) Tax increases and cuts to public spending (i.e. entitlements).
5) Print more money
6) Default totally. This will mean one of several things. We will a)reschedule our interest payments, b)put moratorium on paying c) restructure the debt, etc.

Items 1-2 have already been exhausted. We are practically at 0% interest now. And in a recent interview with one of Fed Chairs, he said it was time to start raising rates to encourage savings. When loan rates are low, so are interest rates on savings accounts. Item 3 was tried, but not announced. China purchased $7.6 bil. in bonds from the US Treasury back in June. That was China’s first increase in bond purchases since October. It now has $1.15 tril. in US holdings. This came after it sold US bonds for 5 straight months.

That leaves us with 4-6. Number 4 is the crux of the current debate. We will have to do both. But Congress is now looking for which groups they can slaughter with the least political consequence to themselves. We have already done 5 to some extent. For the Treasury to do Quantitative Easing, it basically bought back debt using newly printed money. And now we are on the brink of number 6.

So what has happened to other nations who defaulted? Well look no further than Europe today and the EURO.
1) Military spending is usually the first on the chopping block. Notice that we are arguing now with Europe over its lack of military funding. And we are looking to cut ours. Fine with me.
2) If there is a default or restructuring, there are usually increased conflicts with creditors. This leads to political & economic instability. Notice that there has been talk of the end of the Eurozone because the Germans are quite angry at the Greeks and Irish. See Cartoon for other possibilities.

3) Investors are dumping the Euro and running to the Swiss Franc. And they are dropping the dollar as well. The value of the Swiss Franc has been on the rise for over a year. One year ago, I was in Switzerland getting a SFr1 to $1. We were there for 3 weeks and by the end, we were getting SFr.96 to $1. Today, it is SFr. 817 to $1. And China has been pushing for a second reserve currency.

This will devalue the dollar and increase inflation across the board. Basic economics tells us that inflation leads to less job creation, higher prices, increased poverty, and capital flight. It would have a much worse effect that any tax hike because it would be broad-based and not necessarily controllable. Time for the House to get their collective heads out of their asses. Pass a Ceiling, then work on the 2012 budget with austerity measures and tax hikes.