Despite the disaster and pain of September 11, 2001 for Osama Bin Laden success was not measured by body count. It was measured in deficits, in higher borrowing costs, and in investments we could not or did not make in our country’s future. In a 2004 video tape, Bin Laden said, "We are continuing this policy in bleeding America to the point of bankruptcy… We, alongside the Mujahedeen, bled Russia for ten years until it went bankrupt and was forced to withdraw in defeat." Bin Laden understood one very important thing that we as a country have failed to understand: superpowers cannot be defeated in the battlefield; they are defeated by their own arrogance. For ten years, Bin Laden and his cohorts forced the Soviets to fight an unwinnable war in Afghanistan. This helped “bleed” the Soviets of their resources until their fragile economy came crumbling down. We are reaching ten years since the September 11 attacks, and nearly three months after Bin Laden’s death, the Republicans are helping him finish the job.
The debt ceiling debate involves two distinct groups of people. The first group includes those genuinely concerned about the future of the U.S. economy. These people also know that the full faith and credit of UnitedState’s government is crucial for our nation’s future. The faith that the world confers on the U.S. is what makes the global economy work. Keep in mind that despite all the rhetoric and exuberance about China, Brazil, Russia, India, or whatever other flavor of the day country, the U.S. economy still represents a third of global GDP. Furthermore, the U.S. dollar is the global currency. More importantly, all of this economic activity is almost exclusively predicated upon the world’s confidence in America. Take away the confidence and you take away the world as we know it and America’s place in it. This brings us to the second group of people. Simply put, these are the arrogant know-nothings who say things like “let the banks fail,” or “let the government shut down,” or worse yet, “let the government default.”
I believed that the 2008 Presidential election was the most consequential election in my lifetime. Not only did we elect the first black president, but we also had the opportunity to change the direction of our country away from perpetual war and irresponsible fiscal policy. There was a great deal of excitement. I did not think that there would be another election that can match the magnitude of 2008. However, I was wrong. It turns out that the 2010 mid-terms may actually have more consequence and greater impact in the long run.
The 2010 mid-terms brought the arrogant know-nothings to power. These are people who gleefully and unapologetically wallowed in their ignorance while living by principals that are rooted in paranoia and catch-phrases rather than logic. Their philosophy is “end government by any means necessary.” End the U.S. government by any means necessary? That statement should stir an uneasy feeling in your stomach. Think about who made it his life’s mission to destroy the U.S. and render it another failed superpower? That’s right – Osama Bin Laden. I know what you’re thinking: The Tea Partiers don’t want to destroy America; they just want to destroy government. However unless you’re an anarchist, that’s not an argument that makes sense. If government is shut down, economic activity slows down. If government defaults, economic activity may effectively stop and we may plunge into a depression – ipso facto, the end of America as we know it. This may sound like a hyperbole, but it is not. It is a real possibility.
Anyone who knows anything about finance knows one fundamental thing: the concept of the “risk-free rate.” It’s a simple concept whose definition is embedded in the concept itself – risk-free rate. It is the return on any investment that is wholly risk free. In other words, it is the one place where you, your grandma, pension fund, or foreign country can put your money, get a return and without fear of ever losing it. It is free of risk – no risk. Where is this magical place where I can fly without fear of ever falling? The answer is U.S. Treasuries. Why are U.S. Treasuries risks free? Because the United States government has always paid without delay or complaint. In fact, it is written into the U.S. Constitution that government debt “Shall not be questioned.” No other modern government or nation has demonstrated this capacity; hence why U.S. Treasuries are risk free. That is until now.
For the first time in American history, the United States is in real danger of default. For the first time in American history, the United States government may not meet all of its obligations and fail to meet its constitutional responsibility. So, aside from the obvious consequences, what does this mean? I don’t know. But we can make reasonable inductions.
First, essentially the entire global equities and bond markets are valued using the risk free rate. If you know the cap-m model for deriving a stock price, you know how important the risk free rate is. So if suddenly the U.S. defaults or delays its payments to its bond holders, the risk free rate is no longer risk free. Does the market then continue to use U.S. Treasuries to value assets? If so, does the market use the downgraded and higher rate? And if the market chooses to move away from U.S. Treasuries as a basis for valuation, what will the new risk free rate be? How about GE’s corporate bond rating or a British or French government bond? They’re both triple-A. However regardless of the option that the market uses, one thing is certain: the new risk-free rate will be a higher interest rate than what we are all used to with U.S. Treasuries.
Second, a higher risk-free rate means everything will cost more. Although your stock portfolio will likely be worth more in the short run, inflation will also be higher, at least offsetting your gains and likely decreasing the real value of your portfolio. The cost of borrowing for everyone will go up. Bond yields are also likely to go up as investors sell because they fear higher borrowing rates will cut into corporate profits and jeopardize a company’s ability to service its debts. What about your mortgage? It will likely go up as well because your interest rate will go up too. Don’t forget that your mortgage interest is also based on the risk-free rate. That’s not all. Credit cards, car notes, student loans, and virtually every other kind of loan will see a rise in interest rates thus an increase in the loan payments. Once again, that’s not all.
Third, one of the least known markets is the commercial papers market. This is where giant corporations like GE float short term bonds to pay their bill, including payroll. The commercial papers market is almost $2 trillion in value. The paper that is exchanged in this market is very short term, anywhere from one day to nine months. Companies with excellent credit float collateral-less bonds to raise capital so as to meet their daily operational needs. However if their costs of borrowing go up, they may simply decide to trim operations by letting some excess worker go. This would not be a medium or long term decision. Companies will likely start laying people off as soon as their borrowing costs go up. Keep in mind that an increase in interest rates would not only increase their cost of borrowing in the papers market but also their cost of servicing their other short and long-term debts. It likely would be a cost they simply cannot afford or had planned for.
Right now you’re thinking, “all these calamities from not raising the debt ceiling?” My response is maybe. These are all logical and reasonable results, and what’s worse is that the reality may actually be far worse. For the sake of perspective, think about your own credit. If you’re late on your credit card payment, the credit card company can raise the interest rate on that credit card and reports you to the credit bureaus. Once the bureaus have your late payment in their records, your credit score goes down. The other credit cards that you have see your new lower credit score and suddenly see you as riskier. Therefore, they all raise their interest rate on you as well. Suddenly, your minimum payments go up as well as the total amount that you owe. In addition to this, you want to buy a car and a house. However given your new lower credit score, the cost of buying those things are higher for you. More importantly, the net present value of all your personal assets suddenly decrease. If you take this scenario to its logical and extreme end, you end up broke, drunk and on the street. The same can be said about the U.S. and its fiscal problems.
In no time in American history has the United States failed to meet its financial obligations. In fact after the revolutionary war when George Washington and Alexander Hamilton could have easily said we will not pay old debts because they are not ours, they paid them anyways. They understood that the perception of the country would be damaged should the government fail to meet its debt obligations. In an economy like ours, perception is everything. Right now, we are seriously considering default as an option. Although the U.S. is fully capable of paying its bills, the House Republicans are saying “screw it; we don’t want to pay.” By the way also keep in mind that raising the debt ceiling is not to pay for new programs and new government whimsies, it is to pay for things that we have already consumed like the wars in Iraq and Afghanistan, the Bush Tax Cuts, and the Medicare Drug Benefit. All of these were Republican initiatives and now the Republicans don’t want to pay for them. It’s like them going to a restaurant, eating everything on the menu, and trying to skip without paying the bill.
Let’s have a balanced approach to saving our economy. No one is advocating for perpetual growth in government debt. We need to make cuts but we also need to raise taxes -dramatically. The new Republican Party is hell bent on destroying America. Their plan is simply default, shut down the government, and make sure America is not making any plans for its future. As cynical as this may sound, I can’t help but think that the Republicans learned everything they know from Osama Bin Laden.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.