The stock market is blissfully ignoring what it believes is a short term and relatively minor issue arising from a continuation of the deadlock that has plagued Capitol Hill for the past few years - the absence of a continuing resolution (CR) to fund government spending now that spending authority has been exceeded and the government is in partial shutdown. The conventional wisdom is that "everyone knows a CR will eventually be passed, this is just politics as usual." The market is also in apparent disbelief that the government will not approve an increase in the debt ceiling to permit the borrowing needed to fund the government beyond its currently authorized debt limit which is likely to be met within weeks. Again, the conventional wisdom is that this is politics "as usual" and there is no market fear that America will default on its debt obligations. After all, the United States prints its own currency and can always pay its bills with new money.
SA contributor Joseph Stuber wrote a recent article laying the groundwork for a debate on the subject entitled: "Obama and Lew say this time it is serious. Are they just grandstanding or is this time different?"
Stuber concludes there is a likelihood of a default with both bonds and stocks impacted negatively and a bid for gold emerging. It is hard to fault his logic. But there is no sense of foreboding in his article, just a common sense review of the issues.
Among other things, Stuber refers to the unfunded Medicare obligations totaling $42.8 trillion and comparable unfunded Social Security obligations of another $20.5 trillion. Add those to existing government debt of about $17 trillion and you have total obligations of about $80 trillion.
Before continuing, I want to pause for a moment to look at a chart of the path U.S. debt has taken compare to growth in income.
You don't have to be an economist to see that payment of interest and principal on the debt obligations is not going to be covered by tax revenues any time soon. I suggest that situation has been stable for two reasons without both of which the United States would be facing a major economic crisis. First, central bank bond buying (so called Quantitative Easing or QE) has driven down interest rates to where the interest payments on the national debt are manageable. In parallel, the same bond buying has provided a market for the growing parade of government bond issues, either directly through the Fed buying newly issues bonds or indirectly by pushing so much capital into the system that purchases by normal bond customers are sufficient to absorb the new issues.
There are about 115 million households in the United States. $80 trillion of debt approaches $700,000 debt per household. Of course I am including the unfunded Medicare and Social Security obligations as debt. Unless the government reverses these entitlements, they are debt. And the recipients depend on the payments so there is a limited ability to roll them back.
Brad Plummer wrote an article in the September 11, 2013, Washington Post dealing with just the debt issue (including private debt but not the unfunded obligations for Medicare and Social Security).
He included a telling chart, reproduced below:
It is not a pretty picture. It is a manageable picture because the $312,000 of debt is being funded at very low interest rates. At 3% interest, for example, interest costs per family would run $9,360 a year from an average $52,000 family income.
Of course the low rates and the ability to ignore unfunded entitlements make the picture look better than it is. If the average income rises, the situation improves but if interest rates rise it deteriorates.
Let's turn our minds back to QE, which I see as an euphemism for printing money. Print money and use it buy back debt and you can even make government debt decline if you buy back debt at a rate greater than its new issues. Why not just buy it all back and be done with it? The answer is the other side of printing money, inflation. The central bank is trying to help manage government debt without triggering massive inflation. It wants inflation nonetheless, since debt obligations are fixed amounts and inflation artificially increases incomes while the obligations remain fixed, with the bond investors suffering as they receive repayment dollars that have less purchasing power than the dollars they loaned.
This apparent Ponzi scheme works like any Ponzi scheme, that is, as long as there are new buyers for bonds both principal and interest on the outstanding bonds can be funded from exponential increases in new borrowing, and the books can be balanced by inflation so that lenders get back what appears to be the amount they loaned but in fact is substantially less.
What if the poor dupes buying the bonds go on strike, unwilling to purchase the next issue? That is a subject very close to the hearts of central bankers. A major financial crisis can result with massive defaults, much lower bond prices, much higher interest rates and substantial damage to economic activity. It is not what the government wants in the U.S. any more than it was what the government of Greece or Spain wanted, but it is possible.
All Ponzi schemes are vulnerable to changes in sentiment. As long as potential investors believe in the "full faith and credit" of the U.S. government and see U.S. dollars as a "safe haven" investors can be found to keep the charade going.
A default could change all that. Not a narrow, short term and highly technical default, but a real and ongoing "we can't pay you what we owe you" default.
When Greece hit that wall, other Euro members pitched in with one bailout after another to stabilize the country's finances. The U.S. is not Greece and is so large and so important to the world economy that no one could bail it out. If the U.S. defaults, it is everyone for themselves.
Politics is one thing but playing with fire is another. Right now, the elected members of the House and Senate are playing with fire. Don't ignore the risk. Protect your portfolio with puts or a sizable short book, and stay away from long bonds.