Is it Time to Worry About the U.S. Government Defaulting on its Debt?

In finance, the interest rate on short-term government debt is commonly known as the?Risk-Free Rate . It is perceived to be “risk-free” due to the widely held belief that the the U. S. Government poses no default risk. The risk-free rate serves as a crucial foundation for comprehending the anticipated returns associated with various investments.

The?Debt Ceiling ?represents a legislative boundary implemented by the government to regulate the extent of the national debt. Typically denoted by a specific dollar amount, this ceiling acts as a restriction on the government's capacity to exceed a predetermined threshold in spending. Its purpose is to prevent unbridled borrowing by the government, maintaining fiscal discipline and averting a situation where debt becomes unmanageable.

In the event that the government reaches the debt ceiling and is unable to secure additional funds for fulfilling its financial commitments, the looming danger of defaulting on debt payments arises, carrying potential severe repercussions for the economy. To avert such a scenario, the government must undertake one of three measures: curtail its spending, enhance revenue generation through taxation, or pass legislation to raise the debt ceiling. These actions become essential to ensure that default is avoided and financial obligations are met.

As am I sure you are aware, the United States government has reached its “debt ceiling” and now requires a congressional act to raise the borrowing limit.?Similar to the events in 2011 , the House of Representatives, controlled by the Republican party, has voted to increase the limit but with conditions aimed at imposing restrictions on future expenditures. The President and members of his party generally believe that the limit should be increased without conditions. Nevertheless, if the limit is not raised, Treasury?Secretary Janet Yellen has projected that the government might face difficulties meeting its obligations as early as June 1st .

Whenever the U.S. Government's debt approaches the debt ceiling, it is common to for?officials and pundits to assert that "The U.S. government has never defaulted on its debt." However, as highlighted in?this article , this assertion is false. In reality, the U.S. government has experienced four instances of default on its debt, as highlighted below in the words of The Hill Opinion Contributor, Alex Pollock:

1. The default on the U.S. government’s?demand notes ?in early 1862, caused by the Treasury’s financial difficulties trying to pay for the Civil War. In response, the U. S. government took to printing pure paper money, or “greenbacks,” which during the war fell to significant discounts against gold, depending particularly on the military fortunes of the Union armies.
2. The overt default by the U.S. government on its?gold bonds ?in 1933. The United States had in clear and entirely unambiguous terms promised the bondholders to redeem these bonds in gold coin. Then it refused to do so, offering depreciated paper currency instead.?The case ?went ultimately to the Supreme Court, which on a 5-4 vote, upheld the sovereign power of the government to default if it chose to. “As much as I deplore this refusal to fulfill the solemn?promise of bonds of the United States,”?wrote ?Justice Harlan Stone, a member of the majority, “the government, through exercise of its sovereign power…has rendered itself immune from liability,” demonstrating the classic risk of lending to a sovereign. In “American Default ,” his highly interesting political history of this event, Sebastian Edwards concludes that it was an “excusable default,” but clearly a default.
3. Then the U.S. government defaulted in 1968 by?refusing to honor ?its explicit promise to redeem its silver certificate paper dollars for silver dollars. The silver certificates stated and still?state ?on their face in language no one could misunderstand, “This certifies that there has been deposited in the Treasury of the United States of America one silver dollar, payable to the bearer on demand.” It would be hard to have a clearer promise than that. But when an embarrassingly large number of bearers of these certificates demanded the promised silver dollars, the U.S. government simply decided not to pay. For those who believed the certification which was and is still printed on the face of the silver certificates: Tough luck.
4. The fourth default was the 1971 breaking of the U.S. government’s commitment to redeem dollars held by foreign governments for gold under the?Bretton Woods Agreement . Since that commitment was the lynchpin of the entire Bretton Woods system, reneging on it was the end of the system. President Nixon?announced ?this act as temporary: “I have directed [Treasury] Secretary Connally to suspend temporarily the convertibility of the dollar into gold.” The suspension of course became permanent, allowing the unlimited printing of dollars by the Federal Reserve today. Connally notoriously?told ?his upset international counterparts, “The dollar is our currency but it’s your problem.”[i]

Although not without precedent, a U.S. government debt default would carry substantial repercussions, at both domestic and global levels. Some potential consequences could include:

Financial markets:?A debt default could cause disruptions in financial markets, leading to increased volatility and potential declines in stock prices. It may also result in higher borrowing costs for the government and businesses.

Confidence and creditworthiness: A default could damage the perception of the U.S. government's creditworthiness, leading to a loss of confidence in the economy. This might result in higher borrowing costs for the government in the future and a negative impact on the country's overall economic stability.

Economic slowdown:?A default could potentially lead to an economic downturn or recession. It could reduce government spending, increase borrowing costs, and negatively affect consumer and investor confidence.

Global implications: Given the central role of the U.S. economy in the global financial system, a U.S. government debt default could have ripple effects globally. It might cause disruptions in international markets, affect the value of the U.S. dollar, and impact other countries' economies.

Possible “Technical Default”:?To avoid defaulting on the debt, the Treasury might make prioritization decisions which could result in dramatic cuts to government services, social security payments and other government expenses. While this would not be a default of the obligation to pay its debts, this would be considered a “Technical Default” as the government is failing to pay it other obligations even as bond payments were made on time.

How Should We, as Long-Term Investors, Approach a Potential U.S. Government Debt Default?

We should start by acknowledging that despite being labeled as the “risk-free” rate, government debt has always been susceptible to inflation, posing potential risks to purchasing power. Furthermore, holding longer-term government bonds exposes investors to significant interest rate risks, as evidenced by the returns on long-term government bonds in 2022. In reality, there is no investment devoid of risk, just as there is no world devoid of uncertainty. The key lies in determining which risks we are willing to embrace and whether we are adequately compensated for undertaking those risks.

Beyond the risks associated with inflation, a recent reminder emerged regarding the vulnerability of bank deposits that surpass FDIC insurance limits. In the event of the government's inability to fulfill its obligations, it raises the question of whether the FDIC possesses the financial capacity to meet its own commitments.

Secondly, despite the theatrical act unfolding in Washington D.C., all parties involved are cognizant of the grave consequences associated with a default, making it highly probable that a resolution will be reached. While it would be incorrect to claim a 0% chance of default, the likelihood remains relatively low. In the event of a default, if you hold government debt, it is probable that both the principal and interest would eventually be paid, albeit with potential delays. While no one can predict the exact outcome, considering the potential long-term consequences on the U.S.'s borrowing capacity at reasonable rates, it becomes difficult to envision a scenario where a resolution is not ultimately achieved.

In the last week, Bill Gross, the legendary bond manger was quoted last week in a?Market Watch article :

But rest easy, says our?call of the day?from the most unworried?billionaire Bill Gross who advises investors to go out and buy bonds because this too shall pass. “I think it’s ridiculous. It’s always resolved and not that it’s 100% chance, but I think it gets resolved.?[ii]

It is important to maintain adequate liquidity outside of treasury securities. While the markets sort out the uncertainty of the situation, there is a possibility of significant volatility in treasury bond prices, making it challenging to sell substantial amounts of treasury bonds if needed.

As a concluding thought, your long-term portfolio likely consists of a well-diversified blend of corporate and government bonds. Interestingly, this diversified mix may act as a valuable diversification tool if any of the negative impacts mentioned earlier come to fruition. In times of economic uncertainty, high-quality fixed income investments can offer a defensive position, potentially providing stability and serving as a source of protection.

To our clients, as always, TandemGrowth Financial Advisors is here for you. Whether you wish to discuss your investment strategy or talk through any concerns you may have,?please do not hesitate to reach out to us.

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[i] ?https://thehill.com/opinion/finance/575722-the-us-has-never-defaulted-on-its-debt-except-the-four-times-it-did/

[ii] ?https://www.marketwatch.com/story/its-ridiculous-buy-short-term-treasury-bills-because-debt-ceiling-deal-will-come-says-bond-legend-bill-gross-751040c9