FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
October 8, 2013

IN THIS ISSUE:

1. Jobs Report Delayed, First Time Since 1996

2. America Has Defaulted On Its Debt Before

3. Catastrophic Consequences of a Debt Default

4. So What Really Happens on October 17?

5. Only 17% of Government is Really Shut Down

Overview

The Treasury Secretary has warned that his agency will exhaust the “extraordinary measures” it has used to fund the government on October 17. On the Sunday talk shows, he warned of “catastrophic consequences” if Congress doesn’t raise the statutory debt ceiling by then. So, over the next nine days, you’ll be hearing ominous forecasts of what will happen if the US defaults on its nearly $17 trillion national debt, or even some of it. Sound familiar?

Late last week, President Obama warned that he would not negotiate on the debt ceiling until Congress passes a “clean” continuing resolution to get the government funded and fully open again. Most Republicans are hanging onto their demand that the Obamacare mandate for individuals be delayed a year. If both sides hold out, increasing the debt ceiling could be tough.

Somehow, these debt ceiling fights seem to get resolved at the very last minute, but the uncertainty can be brutal for the markets. In 2011, stocks lost around 19% of their value as this game of chicken played out. Some expect the current debt ceiling fight will be even more harrowing since Obama doesn’t have to worry about re-election.

We’ll talk about all of this and more as we go along. Let’s begin by looking at the latest economic reports, or lack thereof, as was the case with last Friday’s unemployment report that was furloughed by the Obama administration, supposedly due to the government shutdown.

Jobs Report Delayed, First Time Since 1996

The Bureau of Labor Statistics (BLS) didn’t release its monthly employment report on Friday, marking the first time in more than 17 years that a government shutdown prevented the agency from fulfilling its duty. The news wasn’t a big surprise since the Labor Department’s website announced on Thursday that it wouldn't issue the report due to a lapse of funding.

The last time the BLS delayed the jobs report because of a shutdown was in 1996 when the government was in the middle of a 21-day dispute. If the 1996 delayed report is any indication of how long investors will have to wait for the September 2013 data to emerge, it could be another three weeks or so.

Investors are relying on Wednesday’s ADP monthly private payroll report and Thursday's weekly jobless claims to get a sense of the current labor situation in the United States. ADP reported 166,000 private payroll jobs were added in September, while economists surveyed by Bloomberg Data were expecting a rise of 180,000. Initial claims for state unemployment benefits rose by 1,000 to 308,000 in the last week of September, slightly less than expected.

Economists polled by Thomson Reuters were looking for nonfarm payrolls in September to rise 180,000 and for the unemployment rate to remain unchanged at 7.3%. The embargo of last Friday’s jobs report suggests that other key economic reports from the government will also be delayed just ahead, as long as the shutdown continues.

America Has Defaulted On Its Debt Before

If you ask most Americans, they would say that the US has never defaulted on its debt. Many in the media and even Obama’s press secretary recently, have recently stated that the US has never defaulted on its debt. However, after the US won its independence from Britain in the late 18th century, the country was deeply in debt, owing about $79 million to creditors. Many politicians argued that the nascent country should repudiate its debts altogether and start fresh.

Alexander Hamilton convinced lawmakers that the wiser move was to consolidate state debts into federal debt and restructure it. Some would argue that it then took the path of modern Greece in the form of a debt swap. The new government restructured its debts, with decidedly harsh terms for creditors, and a large part of the face value of the debt was written off. In other words, it wasn’t paid. Although it was a very long time ago, it was a default.

Standard and Poor’s cites two criteria that equate to a default: 1) that investors will receive less than they were promised in the original securities, which was definitely true in the case of Hamilton’s debt swap, and 2) the swap was “distressed” rather than “purely opportunistic.” Hamilton’s debt swap was clearly made in distress.

The other instance of US default came during the worst years of the Great Depression. In 1933, President Roosevelt devalued the dollar against gold. That violated the so-called gold clause, which required that all public debts be paid in gold coin of a fixed weight. The 1933 devaluation effectively amounted to paying off debts with devalued currency, which is widely viewed as a default.

There have been other instances of default that were due to malfunctions. For example, in April and May of 1979 during the height of another debt ceiling debate, computer glitches resulted in the failure of the US to pay interest on $122 million in Treasury bills, which in the strict sense of the word, was a default. The US was sued by bondholders but they were later paid in full with back interest.

The point to be made is that the US has defaulted on portions of its debt in the past, contrary to what most people believe. Do I think it will happen this time? No. But what worries me is that both sides are so politically dug in. With Obama demanding that the government be reopened and fully funded before he will even consider negotiating on the debt ceiling, and with the House Republicans demanding that the Obamacare individual mandate be delayed for a year, there seems to be no desire to compromise on either side.

Catastrophic Consequences of a Debt Default

As noted above, Treasury Secretary Jack Lew made the rounds on the Sunday shows warning that “catastrophic consequences” will result if the US goes into default. Last Thursday, the Treasury issued an unusually ominous report that warned of catastrophic risks to the economy in the case of default. These dire warnings by the Treasury are no doubt intended to instill fear in the minds of lawmakers and their constituents, but they also suggest that such fears reside within the administration as well. The general public is uneasy as well.

Given the seriousness of the situation, perhaps it would be insightful to look at who (or what) holds our $16.7 trillion in debt. By far the largest owner of federal debt is the combined Social Security Trust Fund and the Federal Disability and Insurance Trust Fund. In case of a default, all of these recipients would be worried about whether they’ll get their full payments.

The second biggest holder of Treasuries – about 12% of the total – is the Federal Reserve, which reportedly has 91% of its assets backed by US government debt. If the value of those assets were to decline significantly, which they would in a default, US creditors here and abroad could conclude that we have little or nothing of value backing the dollar.

Third, the Chinese own apprx. 11% of US debt. That $1.4 trillion represents about a third of the reserves of the People’s Bank of China. As one of the largest buyers of US Treasuries, a debt ceiling scare could prompt the Chinese to slow their purchases at the least, or start selling them off at the worst.

And this isn’t even half of it.

Money market funds, which are used by virtually everyone with savings or investment accounts, are also heavily loaded with Treasuries. So are most bond funds and so-called balanced growth and income funds. A default on US debt would not only cause money funds to “break the buck” – that is, not be able to pay 100-cents for each dollar invested – but would also cause forced selling by countless other funds that are mandated to immediately sell any asset that has defaulted.

That could easily put nearly $1 trillion of Treasuries on the market, which would likely cause interest rates to spike and normal borrowing/lending transactions would effectively end.

Speaking of banks, the US banking industry holds over a trillion dollars’ worth of Treasuries and another trillion dollars of government-issued mortgage-backed securities. If those bonds were to go down in value, the banks would also have to write down the value of those assets and, in essence, wipe out much of their equity. It could make many banks insolvent.

To summarize, a debt default is unthinkable because it would trigger a huge reduction in the value of US debt, which would go beyond disrupting Social Security payments. A default would disrupt money markets and bond funds, slam the brakes on lending, cause interest rates to spiral, make many of our banks insolvent and deal a blow to our foreign trading partners and creditors around the globe. This would quickly throw the US and the world into an economic crisis.

These are just some of the reasons why a US default is not likely to happen.

So What Really Happens on October 17?

The US Constitution is clear (Article I, Section 7): “All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills.” Since the House Republicans have not passed a continuing resolution, “non-essential” government services were shut down last week.

As noted above, we have been repeatedly warned by the Treasury Secretary and President Obama that the government will be unable to continue paying its bills – including interest on the federal debt – starting just nine days from today. However, I believe there are other mechanisms and tricks the Treasury can use to extend that deadline, if necessary.

One simple fact is that tax revenues continue to flow into the Treasury every day. The IRS estimates that tax revenues this year will be about $2.3 trillion. The interest on the federal debt for the 12 months ended September is estimated to be $420 billion. While much of those tax revenues have already been received (and spent), there will still be more than enough revenue to pay the interest on the national debt, contrary to what you hear in the media.

More specifically, in October, federal receipts are estimated to be apprx. $200 billion, while interest owed on the debt is $25 billion. Principal can be repaid by issuing new debt and rolling it over. In other words, any “default” would be a political choice not to pay interest on the debt. Not surprisingly, the Treasury Secretary didn’t mention this on the Sunday morning talk shows.

If that’s not enough, there are many (especially on the Left) who believe the president has the authority, under Section 4 of the 14^th Amendment, to raise the debt ceiling by Executive Order. Many others dispute that, of course. In the 2011 budget/debt ceiling battle, the Obama administration elected not to go the 14^th Amendment route, but who knows this time around?

In addition to a variety of possible Executive Orders the president could issue to allow the Treasury to continue borrowing beyond October 17, there are some other “extraordinary measures” the Treasury could use – if absolutely necessary – to keep issuing debt. Those include minting platinum coins, issuing so-called “Premium Treasury Bonds,” etc.

In short, I do not believe the government will default on its debt on October 17. Nor do I believe that one penny of the interest on the national debt will fail to be paid on that day or those thereafter. There is a Forbes story in SPECIAL ARTICLES below that agrees with me, although not for all the same reasons.

I think the most likely course is some kind of compromise next week, although with this president, we just don’t know how far he will go. It was widely reported yesterday and again today that President Obama said, “I’d rather default than negotiate.”

You’re kidding, right? Maybe not. Larry Kudlow blasts Obama for this position in a story you’ll find in the links below.

Yet even if the debt ceiling is not raised by October 17, I think there will be some creative ways trotted out to let the Treasury continue borrowing. Unfortunately, Obama may find a way to bypass Congress if the impasse continues.

Only 17% of Government is Really Shut Down

Most of us know the phrase "government shutdown" doesn’t mean the entire US government is shut down. So in a partial government shutdown, like the one underway at the moment, how much of the government is actually shut down, and how much is not? One way to measure that is in how much money the government actually spends.

The shutdown is supposed to affect “discretionary” government services, including the military. However, last week Congress passed and President Obama signed a new law that ensures full pay for the military, which is a huge chunk of the federal budget. And Congress has been busy exempting other government services from the shutdown.

The Congressional Budget Office and the White House Office Management & Budget estimate that 83% of government operations continue, despite the government shutdown. Only 17% of government operations are closed down.

It’s no wonder then that both Republicans and Democrats appear to believe they can ride the shutdown out, at least for a couple of weeks until they try to resolve the debt limit crisis due to arrive on October 17. No wonder congressional approval polls are in a nosedive!

Game of “Chicken” is Bad for the Markets

The US stock markets essentially brushed-off fears of a government shutdown initially. But as the shutdown has continued, and as fears that it won’t be resolved before October 17 grew, the stock markets have taken it on the chin. Stocks have now declined for two weeks in a row.

If this debt ceiling melodrama plays out like it did in 2011 – when stocks shed apprx. 19% of their value, as shown above – it could happen again. If the debt ceiling is not raised, and there is a perceived default, it could be much worse than in 2011. When you have a president who says he would “rather default than negotiate”, anything is possible. Buckle your seatbelts!

Best regards,                                                 

Gary D. Halbert

SPECIAL ARTICLES

Mr. President: Using the debt ceiling for political leverage is not unprecedented

Kudlow: Obama’s Default Fear-Mongering (must read)

Forbes: U.S. Debt Ceiling Fantasy – No Default

 

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