Despite all the rhetoric and posturing we see in the media and in Washington D.C., it is safe to say categorically that the U.S. Treasury will not default on its debt after August 2nd, even if the debt ceiling is not raised. Not only will the Treasury be able to pay interest on U.S. debt obligations, but there is money for other essential programs as well. However, there will be some serious cutting that has to happen because spending clearly exceeds revenues.
I believe a debt ceiling limit extension will be enacted. However, let?s consider what might happen if the debt ceiling limit is not raised. Here in a Q&A format is what I believe you need to know at a basic level.
Q: What is a default?
A: In this case, a default would be the failure by the U.S. Treasury to make payments of principal or interest on its debt in a timely manner.
Q: In a given month how much does the Treasury owe as interest on its debt?
A: Roughly about $15?20 billion (more on this in a moment).
Q: How much revenue does the Treasury take in on average in a month?
A: Roughly about $200 billion.
Q: Are you saying the Treasury could pay interest on its debt 10 times over (or more) from monthly income?
A: Yes. Therefore the likelihood of not paying interest on its debt is zero.
Q: But, what about redeeming bonds that come due?
A: As bonds come due, the Treasury would again use monthly income to pay them off. This would lower the debt owed beneath the so-called debt ceiling. Then, the Treasury could turn around and issue debt in that amount up to the debt ceiling.
Q: Why then do Treasury Secretary Geithner and others in government make such apocalyptic statement about the horrors of default.
A: I?m afraid Secretary Geithner and others in government are doing the moral equivalent of yelling ?Fire!? in a crowded theater and they are doing so for political reasons rather than financial reasons. They simply do not want any interruptions in the bloated spending underway in Washington and they want to scare Americans into thinking the end of the world is nigh unless the gravy train keeps chugging along.
Math is hard for politicians
Now, let?s do the math to flesh out some of these points. I know that for many politicians and pundits math is hard, but I?ll try to make it as simple as possible. If we do not raise the debt ceiling by August 2nd, we will not default on Treasury obligations. Nor, will we have trouble making Social Security payments. However, there would be a big drop ? roughly 44% ? in government spending because that percentage represents the difference between government revenues which would be about $200 billion for the full month of August and $172 billion for August if we start counting after the first week when the deadline hits. Spending is slated to be over $300 billion that month.
Here are the numbers from an excellent and highly detailed study by the Bipartisan Policy Center (BPC) quoted in this piece [emphasis added]:
?The BPC study found that the United States is likely to hit the debt limit sometime between August 2 and August 9. ?It?s a 44 percent overnight cut in federal spending? if Congress hits the debt limit, [BPC's Jay] Powell said. The BPC study projects there will be $172 billion in federal revenues in August and $307 billion in authorized expenditures. That means there?s enough money to pay for, say, interest on the debt ($29 billion), Social Security ($49.2 billion), Medicare and Medicaid ($50 billion), active duty troop pay ($2.9 billion), veterans affairs programs ($2.9 billion).
That leaves you with about $39 billion to fund (or not fund) the following:
Defense vendors ($31.7 billion)
IRS refunds ($3.9 billion)
Food stamps and welfare ($9.3 billion)
Unemployment insurance benefits ($12.8 billion)
Department of Education ($20.2 billion)
Housing and Urban Development ($6.7 billion)
Other spending, such as Departments of Justice, Labor, Commerce, EPA, HHS ($73.6 billion)
The decision to prioritize payments would fall on the Treasury department, and Powell points out it would be chaotic picking and choosing who gets paid (in full or partially) and who doesn?t?
No doubt picking and choosing who gets paid and who doesn?t would be chaotic. And, lots of programs would not get their funding and that would lead to plenty of screaming. Nonetheless, it should be clear from this exactly how much we are spending in excess of government revenues. And, that could and should lead to a sober assessment of what government can and cannot do.
What about the bond market vigilantes
Earlier, I posted some of the thoughts of hedge fund manager Stanley Druckenmiller who discussed a potential Treasury bond default in a solid piece in the Wall Street Journal. With his experience in the bond market, Druckenmiller?s voice adds a dose of common sense and street smarts to the discussion of the U.S. government debt ceiling and what might happened if the ceiling does not get raised.
In the piece, he pours cold water on the fiery and apocalyptic language being used by Treasury Secretary Geithner, Fed Chairman Bernanke and many others [emphasis added]:
?One of the world?s most successful money managers, the lanky, sandy-haired Mr. Druckenmiller is so concerned about the government?s ability to pay for its future obligations that he?s willing to accept a temporary delay in the interest payments he?s owed on his U.S. Treasury bonds?if the result is a Washington deal to restrain runaway entitlement costs.
?I think technical default would be horrible,? he says from the 24th floor of his midtown Manhattan office, ?but I don?t think it?s going to be the end of the world. It?s not going to be catastrophic. What?s going to be catastrophic is if we don?t solve the real problem,? meaning Washington?s spending addiction.
As he holds Treasuries himself, it is clear that Druckenmiller has his own money on the line.
I have pointed out before that Geithner makes the flying leap from a failure to increase the debt ceiling to actual default, that is non-payment of interest on the debt we already have. Even if the debt ceiling is not increased, the Treasury has plenty of funds to pay interest on existing debt.
The Wall Street Journal continues:
?It?s hard to think of someone with more expertise in the currency and government-debt markets, but Mr. Druckenmiller?s view on the debt limit bumps up against virtually the entire Wall Street-Washington financial establishment. A recent note on behalf of giant banks on the Treasury Borrowing Advisory Committee warned of a ?severe and long-lasting impact? if the debt limit is not raised immediately. The letter compared the resulting chaos to the failure of Fannie Mae and Freddie Mac and warned of a run on money-market funds. This week more than 60 trade associations, representing virtually all of American big business, forecast ?a massive spike in borrowing costs.?
On Thursday Federal Reserve Chairman Ben Bernanke raised the specter of a market crisis similar to the one that followed the 2008 bankruptcy of Lehman Brothers. As usual, the most aggressive predictor of doom in the absence of increased government spending has been Treasury Secretary Timothy Geithner. In a May 2 letter to House Speaker John Boehner, Mr. Geithner warned of ?a catastrophic economic impact? and said, ?Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover.?
It should be no surprise that Geithner is peddling such nonsense and it should be no surprise that Wall Street firms and government dependent agencies such as Fannie Mae are trumpeting similar views. They don?t want the government gravy train to stop chugging along.
The WSJ continues:
?Mr. Druckenmiller is puzzled that so many financial commentators see the possible failure to raise the debt ceiling as more serious than the possibility that the government will accumulate too much debt. ?I?m just flabbergasted that we?re getting all this commentary about catastrophic consequences, including from the chairman of the Federal Reserve, about this situation but none of these guys bothered to write letters or whatever about the real situation which is we?re piling up trillions of dollars of debt.??
Good point. The debt ceiling is a technicality. The long-term issue is the size and scope of government and growing debt is just a symptom of that.
Update: On CNBC last week, Warren Buffett had a very good comment:
I could end the deficit in 5 minutes. You just pass a law that says that anytime there is a deficit of more than 3% of GDP all sitting members of congress are ineligible for reelection.
