Wednesday, October 2, 2013

Uncomfortable Bedfellow

Wall Street pundits, from coast-to-coast, have been worrying themselves sick about the possible failure of Congress to raise the debt ceiling, followed by the first default in history by a country with the reserve currency.  Only a fool would not be worried about this.  It could indeed be frightening, and I have spent quite a bit of time thinking about it.

Think of  it in two ways.  One, what is the probability of Congress failing to raise the debt ceiling?  Two, what are the consequences if they do fail?

First, the worst thing that could happen would be another stalemate.  I would worry less if one side is much, much stronger than the other side.  While I certainly have my preference, my preference is not important.  What is important is raising the debt ceiling.  It doesn't matter to me as an economist if the Republicans or the Democrats "win."

Public opinion is moving strongly behind the Democrats, as a result of the government shutdown.  The longer the shutdown, the stronger the Democrats will be in raising the ceiling.  If that decreases the probability of default, I'm all in favor of that.

Second, in a purely academic world, investors around the world should shun U.S. Treasury Bonds unless they are compensated accordingly, which means a rise in our interest costs and which we cannot afford.  In the real world, the Fed is likely to actually increase, not "taper," quantitative easing or buy enough of the bonds to keep interest rates low.  This may be good in the short term but not in the long term.  Selling the bonds will not be the issue, in the event of default.

Also, I've been reading as much as possible about the reaction of foreigners to a U.S. default, and they appear remarkably sanguine.  One referred to us genially as "those wacky Americans."  Many cannot resist comparing the U.S. government to the hopelessly ungovernable Italian government.  But, nobody is talking about actually losing money on U.S. Treasury bonds.  That does not mean gold will not rise, nor that oil will not fall.  They will, but they are not as volatile as I originally feared.

I expect the stock market will continue to drift downwards until there is some resolution, but this should be a buying opportunity.  That doesn't mean there is no risk.  The credit default swaps on U.S. Treasuries would become quite a bit more expensive, but nobody thinks we don't have the resources to pay our debt.  (Some unknown derivatives linked to the dollar could "blow-up," but all we can do is be prepared to sell quickly, if that is the case.)

I'm now in the uncomfortable position of hoping the shutdown continues long enough to make it certain the debt ceiling will be raised before default can occur.   Now, let us pray . . .