Will the Debt Ceiling Be Catastrophic?

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With the government partially shutdown and the nation moving closer to the debt ceiling, how bad will this mess get? The Treasury Department released a report, which noted, “The United States has never defaulted on its obligations… a default would be unprecedented and has the potential to be catastrophic.”

Catastrophic is a pretty scary word, so what exactly will happen on October 17th, when the nation can no longer juggle the books and needs to borrow more than the statutory limit of $16.7 trillion?

Treasury expects it would still have about $30 billion cash on hand to cover its bills. Between money coming in and obligations, we can make it to the end of the month, but then things gets dicey. On November 1st there is $25 billion bill for Social Security and on November 15th, a $30 billion interest payment on government bonds is due. Without an increase to the debt ceiling, neither will get paid on time, which would qualify as a technical default.

The mere whiff of a default could throw financial markets into disarray. Treasury says that “credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse.”

Most traders agree that if a default were to occur, it could make the August 2011 debt ceiling swoon look like child’s play. In August 2011, Congress came to a last-minute deal to avert hitting the debt ceiling, but it was too late: ratings agency Standard & Poor’s downgraded the credit rating of the United States by one notch and the S&P 500 stock index subsequently dropped by more than 17 percent. Given the bad memories of 2011 and the credit freeze of 2008, there is widespread belief on Wall Street that not even the most extreme members of Congress would allow a default to occur.

Some legal experts have said that the President could invoke emergency powers if Congress could not come to an agreement. According to the New York Times, there are three options: “One is grounded in an aggressive understanding of presidential power, the second in an interpretation of an obscure provision of the 14th Amendment and the third on a choice among three irreconcilable constitutional obligations.” But White House officials maintain that the President will not act alone and that Congress must provide the authority to borrow money.

What about Treasury’s claim that “even the prospect of a default can be disruptive to financial markets and American businesses and families”? There is some evidence that we are already seeing the ill effects of both the government shutdown and the debt ceiling: stocks have dropped about 3.5 percent in the past two weeks and confidence could erode as the negotiations drag on. That’s why the National Retail Federation said that Congress could blow a hole in its holiday sales forecast. “Our forecast is also somewhat hinging on Congress and the Administration’s actions over the next 45 days; without action, we face the potential of losing the faith Americans have in their leaders, and the pursuant decrease in consumer confidence.”

As the battle on the debt ceiling nears, it’s important to underscore that Congress has already agreed to spend a certain amount of money, by virtue of the annual budgets that come to the floor for a vote. After budget resolutions are passed, if the government cannot meet its obligations from revenue, it borrows money by selling bonds. Increasing the debt limit does not authorize new spending commitments; rather it allows the government to finance existing obligations that Congresses and presidents have made.

For decades, lawmakers increased the debt ceiling as a course of business. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit under both Republican and Democratic presidents.

So what’s an individual investor to do? Stick to your long term balanced approach. Looking back to 2011, the year felt like a roller coaster, but it ended more like a merry go-round. The S&P 500 was up by over 8 percent in the spring, was down 12 percent over the summer and finished the year nearly unchanged at 1257.60, a drop of -0.003 percent for the year, the smallest annual market move for the S&P 500 since 1947. While we are rooting for Congress to do something, the best prescription for investors may be to do nothing!

For more, go to JillonMoney.com

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