This Tuesday, Aug. 2, the supposed drop dead date for raising the debt ceiling, is really getting close now. If you listen to the news anchors on television, you probably think that the United States will automatically default on its debt on that date. This is not true.
The United States would default next week only if it declared that it is unable to pay its debts and then failed to pay the interest on the debt due on August 2nd – approximately $29 billion. That will not happen.
By August 2nd the government will have about six times as much in tax revenues as it owes in debt interest and the very first thing it will do is pay that interest whether the debt ceiling is raised or not.
The problem we will have if the debt ceiling is not raised by August 2 or soon thereafter is that the government will not have enough money to pay all of its bills. If the ceiling is not raised, we cannot borrow and, if we cannot borrow, the amount of money available to the government decreases by 42% of the budget (or what the budget would be if we had one).
The costs of Social Security, Medicare, Medicaid and debt service take up some 56% of the budget and, assuming President Obama elects to pay all of those in full, the government would have left only 2% of the budget (instead of the 44% it would have had if it had been able to continue to borrow) to pay for everything else.
Eventually the government will resolve the debt ceiling issue but, until it does so, President Obama will have to decide where to spend that remaining two percent.
Of course, Obama could decide to cut the entitlements but that would be very dangerous politically. And he has easily available funds to cover Social Security outlays, either from tax revenues on hand or, as I pointed out in my last blog, by redeeming bonds from the Social Security Trust Fund, which would leave him with a like amount of tax revenues to spend plus the capacity to borrow the amount of the redeemed bonds without breaking the debt ceiling.
A great long list of government programs would be affected. These include such things as education, scientific research, most federal salaries, the operations of many government departments and agencies, a wide range of defense-related expenditures, agricultural subsidies, welfare programs such as food stamps, unemployment compensation, supplemental security income, family support, national parks – even my pension – amongst many others I assume that any payments missed during this time of shortfall will be made up when the debt ceiling crisis is resolved and the government starts borrowing again.
But if you are dependent on any of the above and do not have some cash set aside, you could be in trouble. And sadly, an interruption in payments and benefits is one of the smaller problems we face.
In the very very unlikely event that there is no resolution ever to the debt ceiling problem, the government will have to immediately cut its expenditures by about 42% per year and keep them that way unless and until it can devise some combination of tax restructuring and growth policies which enable our country to begin a long and very painful climb out of the deepest economic collapse the nation has experienced since the Great Depression. That could take decades.
The more realistic threat, to all of us, comes from a formal downgrade of our credit rating by the big three rating agencies or an informal downgrade by the purchasers of our bonds. But I will get to that in a moment.
First I need to explain that there are two ways in which a nation can default on its debt. The first, a formal default, is covered above. The second, a gradual informal default through inflation, is already underway. I have explained this in earlier blogs but, very briefly: The Fed has been printing money hand over fist to hold down interest rates by buying some 75% of all T-Bills it sells to finance the national deficit.
It has printed more money to loan at zero percent interest to the big banks, which they immediately invest in T-Bills at a risk-free profit of 3.5%. And the Fed printed vast sums of money to enable it to buy toxic subprime mortgages which the big banks held on their balance sheets, posing a risk to their solvency.
All of this money printing is hugely inflationary. In fact the true rate of inflation, not the phony number provided by the government, is already somewhere between eight and nine percent. Most currencies inflate a bit each year.
Because the dollar is the global reserve currency and necessary to enable international trade and to guarantee the currency reserves of many central banks, our creditors are willing to swallow a greater level of inflation in the dollar than they would in other currencies and still buy our bonds. But the size of our debt, the inability of our political system to address the debt issue effectively and the certainty that the Fed, which stopped buying bonds in June, will start again at some point, have all given our creditors pause.
Were it not for fears that the euro may be about to collapse, which drives money from the euro and into the dollar as a safer haven despite our problems, the Fed would already face demands for much higher interest rates as it prepares to sell more T-Bills in August (if the debt ceiling is raised).
Once the Fed starts to buy T-bills again, creditor concerns about the stability of the dollar will grow and so will demands for higher interest rates to mitigate the perceived risk of holding a less stable dollar. But our creditors may not have to wait that long because the big three credit rating agencies, Moody’s, Standard and Poor and Fitch are also concerned. And their fears relate not so much to our seeming inability to agree on the debt ceiling but on the size of the debt and our political will to take the austere measures which will be needed to pay it down.
Look at things from their point of view. The United States is recovering more slowly from the Great Recession than the Eurozone or Great Britain. Our national debt already stands at $14.5 trillion and the President is requesting an additional $2.5 trillion - the largest debt ceiling increase in history - over the next 18 months or so.
Yet the creditors can already see that this will not be enough. In recent years the Fed has bought our bonds to hold down interest rates. Our creditors understood what the Fed was doing and most of them would only buy short term bonds at these artificially low rates. That means that, over the next four years, 61% of our bond debt will mature and have to be paid off.
What will actually happen is that the bond debt will be “rolled over” and new bonds will be sold but these will have to be sold at a higher rate of interest, which will further increase the national debt.
During this period the Treasury will have to buy back or refinance some $4 trillion in short term paper and still cover the Congressional Budget Office (CBO) projected annual increase of $1.5 trillion in the debt. This totals something like $10 trillion additional dollars which the US will have to come up with over four years.
Meantime the total of America’s debt, that is both the government debt and that of the private sector, is some 400% of GDP, far far worse than Greece. The ratings agencies and our creditors can perhaps be forgiven for wondering where all that money will come from!
Considering all of this, I suspect that the ratings agencies will downgrade our credit rating from AAA to AA+ whether we raise the debt ceiling or not.
Neither the Boehner Plan nor the Reid Plan contains spending cuts large or certain enough to cause the agencies to believe that the Congress is serious. The same can be said for major tax restructuring. Interest rates on T-Bills are already under pressure from frightened buyers who themselves fear economic contraction if their dollar holdings are suddenly worth much less.
A reduction to AA+ will cause an immediate jump in those rates, perhaps driven higher if buyers perceive greater risk. Any such jump will lead inevitably to higher interest rates and more rapid growth of inflation in the United States.
By the time this happens we will already be far down the slippery slope to de facto default through inflation. Understand that inflation amounts to a tax, possibly a huge tax, on everybody. Those on fixed incomes or with cash savings suffer the worst. Banks will have to pay more for money and they will pass this along to borrowers.
Mortgage rates are tied to the interbank rate and they too will jump up. Same for any other kind of loan including the rates charged by the credit card companies. But higher rates should also make it harder to borrow money, which would suppress economic activity.
This would produce stagflation, like we saw during the 1970’s, with less economic activity and jobs but higher costs for everything. Businesses borrowing money to conduct trade will also pass that along to their customers. Food, clothing, housing costs, utilities, medical costs – all will go up.
Rapid inflation, which is a real possibility if we do not reduce spending markedly, restructure the tax system to grow the private sector and balance the budget, will destroy our economy and many of us along with it.
I haven’t even begun to describe the huge additional jump in inflation which will take place if all of this leads the international trading community to dump the dollar as the reserve currency. But one thing is clear: All of this rolls downhill and you and I, dear reader, are at the bottom.
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