Debt Ceiling Ignorance And The Horrific Economic Consequences

Includes: BOND, GLD, IYR, QQQ, SPY
by: Markos Kaminis

If investors are at all worried about a government shutdown occurring next Tuesday, then they should be terrified about the possibility of an economic shutdown, should Congress not raise the debt ceiling by October 17. Republicans, Democrats and Independents agree that if the government does not raise the debt ceiling in lieu of not reining in spending, our economy could effectively be shut down. It's because we would test American credibility, by giving those who measure it reason to question it, and that includes more than just the rating agencies. Those nations, institutions and individuals who lend to America and allow us to keep a deep budget deficit without impact to our currency or interest rates might reevaluate the level of their risk carried in investment in us. If that happens, then the default on American debt that would occur, which is referred to today as "technical" because it would be the result of technicalities alone, might tomorrow be remembered as devastating.

First let me explain what the debt ceiling is

The debt ceiling issue is simply pertaining to Congress' authorization given to the U.S. Treasury to raise up to a certain level of debt funding. In this case and in every case in which the debt ceiling has been raised, it has been because more funds were needed to cover expenses already agreed upon by legislators. It's simply making the funds available to cover their own plans. However, the debt ceiling is an important threshold put in place for a reason. One benefit of the debt ceiling is that it makes Americans aware of the level of American debt and stops it from increasing unchecked. The risks born from high leverage are not all too dissimilar for a government than they are for individuals. If we go beyond our coverage abilities, the cost of our borrowing could increase and the credibility of the United States could come into question. Lenders like China and others would demand a better yield, which is the interest we pay to those who buy our government debt. Or, there's the risk, now considered impossible, that demand for our debt would disappear altogether.

The words "economic shutdown" were first spoken by the President on Friday afternoon as he warned Americans about the risks we face if our legislators cannot come to order around the debt ceiling. While we have been to this gate of hell before, we should not take comfort in the fact that similar prior deadlines have been bypassed. Instead, we should not even approach the economic cliff's edge, and do what is best for the American people, because too much is at risk for politics to be at play. The President is correct in saying that we cannot even fathom what might happen if the full faith in credit of the United States is damaged. I'll take a stab at it for you though nonetheless, and briefly describe what might happen to various asset classes and the economy generally should the government default on its obligations.

Economic Impact

The President is correct in saying that we are not even sure what would happen if U.S. credibility is undermined. However, we can say surely that the impact upon the economy generally would be devastating. We would not be able to fund many essential programs and the lifestyle so proudly achieved in America would change to reflect a much lower standard of living. As a result of decreased public assistance and even entitlements and also the failures of American businesses relying on cheap debt funding, American consumer spending would dive. We would find ourselves with excess retail capacity, leading many companies to go bankrupt and stores, industrial facilities and other real estate to go vacant. After a while, vacant properties would evolve into abandoned ones, when real estate owners can no longer fund their ownership nor sell property. Compounding upon the situation, states and municipalities would come under pressure from lower revenue flow from a struggling populace, and civil services would need to be reduced. Slums would grow and real estate development would die off. We could go on forever covering in detail how our healthy economy would suddenly die. The details of how our economy could unwind are frightening, but the impact would not be isolated to America.

Since the world uses the dollar as its reserve currency, with major nations holding U.S. treasury securities and US dollars as backing for their own economies and currencies, then the world economy would be undermined by a failure of US credibility. A global depression would likely result and the prices of all resource commodities would increase due to the lost value of fiat currency globally. The gold standard would likely return and replace the US dollar as the world's reserve currency, but the turmoil would take decades to resolve itself. Global depression and struggle for resources, with unrest the result within nations, would likely intensify pressure on nations to go to war. Chaos might suddenly replace the modern civilized normalcy that we have grown so accustomed to.

What about for investment assets?

Asset Class Security

Friday Change








PowerShares QQQ (NASDAQ:QQQ)









iShares US Real Estate (NYSEARCA:IYR)



Friday's trading is telling, because some of the most important asset classes began to show signs of how they would react if the debt ceiling issue is mishandled. First let's start with equities, which were down across the major indices Friday. If the cost of borrowing increases, it also increases for corporations. Thus, highly indebted companies would face steep increases in the cost of their borrowing when coming back to the bond market, which is something they do often. Still, the cost of debt is not the only rising cost for equities; the cost of equity also increases when interest rates rise, and so it becomes harder for companies to create economic value because the cost they must overcome is higher. When inflation runs between 2% and 5%, these rising costs are offset by rising revenues for a good many companies able to raise prices, so stocks can be a hedge against inflation to a certain extent. However, if interest rates rose in a shocking and quick manner, which would be the case around a debt ceiling debacle, stock prices would decrease, except maybe save companies dealing in and holding heavy amounts of tangible assets, like perhaps those dealing in raw material commodities (basic materials), precious metals and those holding significant real estate assets that are not too sensitive to the economy. Otherwise, the cost of doing business would increase faster than companies could pass them off to customers experiencing a rising cost of living, and so stocks would suffer.

Speaking of real estate, I expect that the value of real estate would initially increase broadly speaking, but due to economic value destruction across the economy, real estate should come under pressure as well. For instance, vacancies would rise over time. Those holding residential real estate would only manage to preserve capital, but selling that real estate might prove difficult with a smaller pool of capable buyers in a suddenly struggling economy. The value of shelter in such a faltering economy would be priceless though.

The value of real estate is affected by more than just its tangible asset characteristic. For a commercial space for instance, if the economy around it is destroyed and vacancies are created and persist, its relative value will decline because of the income potential that will be lost. For a rental property, if a neighborhood is several damaged by an economy gone bad, rental rates will have to come down. They would also be pressured by a tradeoff the landlord would have to make to fill vacancies due to economic issues. So, rising rates are not really a good thing for real estate. In fact, it would also make the cost of ownership higher for new mortgage borrowers, and would so damage the real estate market. This is probably the reason why the IYR declined Friday.

Bonds would obviously drop in value, and this is a big reason why PIMCO's Total Return ETF is lower on the year. Throughout the year, investors have anticipated that interest rates would move higher, likely on the easing of dovish Federal Reserve policy. Nobody could fathom that rates might skyrocket on the loss of the full faith in credit of the United States. But rising rates on that issue would destroy the value of bonds already issued at lower yields than higher demanded new market yields.

Gold & silver; those dealing in the commodities like the miners found in the Market Vectors Gold Miners (NYSEARCA:GDX); and the securities tied to them, including the SPDR Gold Trust and the iShares Silver Trust (NYSEARCA:SLV), might be the only beneficiaries of an American default on its obligations. The reason would be because the dollar would be less desirable along with U.S. debt, and so the world would seek another reserve currency in its place. In my view and in the view of many others, gold and silver are mankind's default currency (pardon the pun). Capital should not run into other fiat currencies because those are all interconnected to the U.S. dollar, due to the reserve ownership of too many other important sovereign nations. You'll take note that the SPDR Gold Shares and the iShares Silver Trust each gained markedly on Friday.

So, in conclusion, you can see why the debt ceiling issue is so important for the American and global economy, and why we should not allow our legislators to play Russian roulette with our lives. Some issues should be placed above political tainting, and each party should put this issue out of bounds from political bargaining. Each and every American and global citizen should be incensed by the happenings in D.C. around this topic because of the great risk at play for each individual life and our common world. Together, we should be clearly saying, raise the debt ceiling Congress, or suffer the unfathomable consequences of supreme ignorance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.