Comments on the US Debt Crisis

In the wake of the Congress failing to vote last night on a measure to raise the debt ceiling, I would like to leave you with another perspective on the pending American debt issues.  This article is from Norman Raschkowan, Chief North American Strategist, Mackenzie (note the image below is from the same source).

The issue: the U.S Congress establishes a limit of total Federal Government debt that the Treasury may borrow at any time – the debt ceiling. It is expected that this “debt ceiling” will be hit by August 2^nd. Unless Congress authorizes a new, higher debt ceiling, the Treasury will then no longer be able to borrow the money necessary to fund the government’s operating expenses or interest costs.

The Republicans now control the House and are thus in a position to prevent passage of the legislation to increase the ceiling. They are using this power to try and force future deficit reduction through spending cuts, while the Democrats want tax increases as part of the plan. In truth, the politicians have a number of options open to them that would not undermine the economic recovery.

For example: entitlement programs (Medicare, Medicaid, Social Security) need to be addressed or no long term progress can be achieved in reducing the U.S deficit. They could introduce clawbacks of Social Security, as we have done in Canada, or they could postpone entitlements from age 62 to age 65 for future beneficiaries (ie. those 45 or under today).

Taxes: they could increase taxes on certain items (gasoline, alcohol, tobacco) to both promote social welfare and stronger finances. They could also introduce a national VAT – the U.S is one of the few developed countries without a Federal sales tax.

This is really political “theatre” that will have important consequences. I am hopeful that they will reach a deal before August 2^nd, because no one wants to experiment with what happens if the government hits the limit. It did happen once before, and the government “closed down” for 6 days (of note: in this scenario, the politicians continue to get paid, just the workers don’t) - this could happen again. And, even if they go past August 2^nd, the U.S will not technically be in default until they miss an interest payment – I believe the next one is due August 15^th. As highlighted in the chart below, the U.S will continue to have revenues in August (income taxes withheld, excise taxes, duties, royalties, etc.), they will just not be sufficient to cover expenses. So, the government will have to choose who they pay, and who they don’t. So long as they choose to pay their interest, and they continue to roll-over maturing notes and bonds (which does not increase the total amount borrowed) they will not be in default – it’s just that their FICO score will drop. And, per the chart below, if they choose to delay payments to defense contractors they will have the $ to pay the military, Veterans Affairs, Welfare, and Federal salaries. They can probably go forward on that basis for 2-3 months if they need to.

Even without a default, I think this will still have a negative economic impact because of the damage to business and consumer confidence. If the U.S does eventually default, the primary issue is not its impact on government finances, it is that people who purchased default insurance will expect to be paid and Treasury bonds will no longer be useful as collateral behind derivatives trades. This could create a lot of turbulence in capital markets because of its impacts on liquidity. Given the 9.2% unemployment level in the U.S, I don’t think any politician wants to be associated with this as we go into the 2012 election year.

Here’s hoping sanity prevails.

Norman

Have a great weekend!  I will be updating the blog with news on the issue as we receive it next week.

Tracey