The Debt Ceiling And Gold: Playing Chicken With 'Default'

Includes: GDX, GLD
by: Han Jun Low

It seems the U.S. has been hogging the headlines, for all the wrong reasons, these past few months. Regardless, there is only one issue I have had my eye on all the while; the root cause of all its woes if you will.

With the government shutdown stretching out longer and longer, it seems as though talk has finally turned towards whether or not a debt ceiling increase is still on the books. A government shutdown to defund Obamacare has turned into one that might lead the U.S. into potential 'default'. How appropriate that the timing for this comes so soon after a proposed intervention in Syria (war, ever the last resort of a malfunctioning economy, postponed but not denied), a government shutdown and tapering being 'postponed' (indefinitely). Perhaps it is all a cosmic coincidence. Perhaps not: extreme debt, together with its co-conspirator rampant inflation, has historically been the root cause of many a failed governing body. Add to that an environment of rising interest rates and declining returns on additional debt and you have a recipe for unavoidable disaster.

The way I see it, there are only three major paths that the U.S. could follow at this juncture.

1) The U.S. Defaults

This is the most obvious of outcomes. The stock market crashes (its artificial boost unable to cope with the severity of the negative sentiment). The housing bubble pops once more. Recession plagues the country. The inflationary tsunami held in check by the barriers of housing/stock speculation floods through the streets. Gold shoots through the roof, dragging gold miners (NYSEARCA:GDX) with it. Faith in the U.S. economy falters and the confidence of the world in the U.S. as a financial power, much less a reserve currency, is shaken for a very long time. As a result, the U.S. would have to recalculate many of its expenditures and work on producing GDP increments without debt.

2) The U.S. Agrees To Severely Reduce Expenditure

Some argue that the U.S. constitution forbids it from defaulting on its debt; what would ensue instead would be a severe curtailment of government spending, one that is imposed by force rather than political consensus (at this point we must all agree that political consensus has been given a fair chance and that the willpower necessary to impose unpopular spending-cuts in the military OR social-spending in a sufficiently large manner would never be found in a political grouping that wants to be reelected indefinitely). The short-run would be especially painful for the U.S. economy, with an impact similar to the first point with the exception of two major distinctions.

First, there would be the additional pain of immediate spending cuts. This is unlike the first scenario, where debt simply disappears into the ether. Real economic production would be severely affected either way, but the economy would face a far more severe recession.

Second, the U.S. only loses some credibility and might retain its reserve currency status. This prevents the more severe currency-related problems that would be prevalent in the prior scenario and provides additional support for the reconstruction of the U.S. economy... Or perhaps another excuse to blow another bubble, though it would be more likely to be the former rather than the latter.

In this scenario, gold is once more given additional support.

3) The Entire Debt-ceiling Debate Turns Into Another False Conundrum

It is always possible that everyone comes back to the table and agrees to give something in return for something in order to prolong the inevitable once more. American politics has become so plagued by theatrics, one has to question how genuine its players really are. Should the debt-ceiling be raised once more, and nothing else changes (there is no war, no further spending cuts, QE continues, etc.), I would expect further minor degradations to jobs numbers, GDP and an acceleration of inflation. Eventually even Goldman would have to reverse its constant predictions of gold being a 'slam-dunk' sell (despite its unexplained bullish position in a certain gold ETF (NYSEARCA:GLD)...).

Gold, if traded in a fair market, might continue to gain ground in this environment. However, it would certainly grow at a slower rate and only gain significantly when another crisis 'crashes' the system. In the end, the cynic in me believes that this is the path we will find ourselves in. Certain 'Optimists' might agree with me, but I believe that the truly optimistic path for a long-run recovery would have to be one of the first two options. The solution for debt cannot be more debt... As I had mentioned several times before, you should not be surprised if something 'unexpected' were to suddenly occur in the gold market and the macroeconomic scene at large.

Disclosure: I am long GDX. 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.