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The Horrifying Consequences of America's Debt Default

The debt ceiling is in the news again, and Washington is arguing over whether the nation can afford to pay its bills or not. Meanwhile, Janet Yellen is warning us of a “calamity” resulting from a default. We take a look at history, and it turns out she might be right…

From Peter Reagan at Birch Gold Group

Treasury Secretary Janet Yellen tends to make a media appearance every year when the U.S. government’s spending has exceeded its revenues so much that the nation’s checkbook hits the “debt ceiling.”

What exactly is the debt ceiling? It’s useful to think of it like a credit card’s built-in credit limit – it’s the maximum amount you’re allowed to borrow. If you spend too much and hit your credit card’s limit, you have three choices:

  1. Call your credit card company and ask them to increase the limit. In our analogy, that’s the same as raising the debt ceiling.
  2. Tighten your belt, spend less and pay down your debt – maybe put in some overtime at work. The national equivalent is balancing the budget (which obviously involves either making more or spending less money).
  3. Stop paying the bill, don’t pick up the phone and hope the credit card company never tracks you down. In other words, default on the debt.

Yellen has made it very clear she’s a fan of option #1. Of raising the credit ceiling, she says:

Congress has to do it. It has to be done. It can’t be something that’s contingent on cuts.

In other words, she’s sided with the Biden administration’s insistence on a “clean increase” not linked to any cuts in current or future spending.

Regarding the other possibilities, Yellen is most concerned about option #3, but says #2 is also a bad idea.

She recently warned that both options #2 and #3 could result in an economic calamity, specifically that:

demands by House Republicans for spending cuts in return for backing an increase are “a very irresponsible thing to do” and risk creating a “self-imposed calamity” for the global economy.

Correct me if I’m wrong, but is she really saying, “We’ve already spent too much to worry about spending more?”

Later in the interview, she clarifies her position on fiscal discipline (what non-politicians might call “living within your means”):

“Congress needs to understand that this is about paying bills that have already been incurred by decisions with this and past Congresses and it’s not about new spending,” Yellen said. She said she believes in making sure that government debt levels are sustainable, “but it can’t be negotiated over whether or not we’re going to pay our bills.”

Okay, so to be fair to the Treasury Secretary, she’s really saying, “We need to open to door to spending money we don’t have in the future to pay the bills right now.”

Honestly, this also sounds like a really bad plan! Just imagine calling up your credit card company and telling them, “Hello I need you to raise my credit limit. I know it’s already maxed out. No, I’m not going to spend any more – well, I already spent more, but that’s a decision I already made. No, it’s too late to change that decision, which is why I really need you to raise my credit limit…”

How far would that get you?

Back to Yellen. Regarding option #3, well, she says refusing to pay the nation’s bills:

would impose a self-imposed calamity in the United States and the world economy.

She finished her remarks to the AP by stating that if the ceiling weren’t raised by June, that “significant economic damage” would ensue.

According to her statements, even if Congress does what she wants and raises the credit limit (Option #1), but doesn’t do it fast enough, there will be “significant economic damage.”

Yikes!

Keep in mind, Yellen does have a habit of making melodramatic statements. (And she, along with nearly every single economist employed by the federal government, was way off base when it came to anticipating consumer price inflation.

It’s comforting to think the hysterics over the debt ceiling showdown and the shock-and-awe headlines about the global financial system falling to pieces are overblown.

That’s comforting, but is it accurate?

What if the debt ceiling stand-off isn’t resolved this time, at the last minute? What, exactly, would happen?

This may be nothing more than a speculative exercise. Even so, I think it’s crucial for every American to understand exactly what’s at stake here…

Just how bad could the U.S. debt default situation get?

Let me be perfectly clear: this debate about raising the debt ceiling has to happen. We must stop pretending that borrowing over a trillion dollars a year is nothing more than business as usual!

Having said that, it’s critical to bring both sides of the debate to the table and get them negotiating.

I’m fairly confident that every politician involved in the debt ceiling standoff knows what is at stake. (Everyone knows it would be really bad to stop paying the bills.)

Even Yellen conceded that she “believes the situation ultimately will be defused because lawmakers can appreciate the escalating danger if the federal government was unable to pay all of its bills.”

After all, that’s how it’s always gone before! Posturing, drawing lines in the sand and erasing them, midnight back-office horse-trading and finally, usually at the very last minute, a deal.

The debt ceiling was raised 74 times from March 1962 to May 2011 – during which the day-to-day, business-as-usual of the federal government was only interrupted a handful of times.

And despite all the ruckus, the U.S. has never defaulted on its debt. (Well, technically during the War of 1812, when the White House and the Treasury Department were torched by British invaders, payments were delayed.)

What if this time is different?

What if the situation isn’t defused, as it has been so often in the past?

What if the debt ceiling isn’t raised, forcing the U.S. into default on its obligations?

\What would an actual, non-technical default look like?

Well, the truth is, no one really knows. Not for sure. Based on historical precedent, though, we can make a few assumptions…

This recent report from Moody’s Analytics cautions that just a short impasse that still sees the debt ceiling raised would have some pretty severe consequences:

the economic downturn ensuing from a political impasse lasting even a few weeks would be comparable to that suffered during the global financial crisis. That means real GDP would decline almost 4% from peak to trough, nearly 6 million jobs would be lost, and the unemployment rate would surge to over 7%. Stock prices would be cut almost in one-third at the worst of the selloff, wiping out $12 trillion in household wealth. Treasury yields, mortgage rates, and other consumer and corporate borrowing rates would spike, at least until the debt limit is resolved and Treasury payments resume. Even then, rates would not fall back to where they were previously. Since Treasury securities no longer would be perceived as risk-free by global investors, future generations of Americans would pay a steep economic price.

That’s right – it’s the economic equivalent of the 2007-2009 Great Financial Crisis even if the standoff gets resolved in just a few weeks! Even if we choose option #1 but don't do it fast enough!

Mark Zandi, chief economist at Moody’s Analytics, delivered a brief summary of the consequences of default, and it wasn’t pretty:

It would create chaos in financial markets and completely undermine the economy.

The economy would go into a severe recession.

The immediate impacts would probably overwhelm us:

  1. Freezing many federal benefits payments such as Social Security, Medicare, Medicaid, veterans’ benefits (healthcare, housing, education etc.), federal nutrition programs and federal housing-assistance programs.
  2. An extreme recession, likely comparable to the Great Depression, including massive job losses.
  3. Higher borrowing costs, when credit is available at all – because even the highly-liquid short-term commercial paper and Treasury bill markets would grind to a halt.
  4. Extreme volatility in financial markets.
  5. A further downgrading of the U.S. global credit rating would add insult to injury by making future borrowing even more expensive.

Maybe Treasury Secretary Yellen is right to use the word “calamity” to describe these consequences.

While we don’t know with certainty what an outright default would look like, we have seen the debt ceiling stand-off escalate perilously close to default.

We can’t tell the future, but we can look to the past to tell us what may happen next…

How it played out last time

If history repeats itself, we’re probably looking at a reenactment of the debt crisis of 2011. Here’s a play-by-play of how that affected financial markets:

The S&P 500 fell nearly 17% between July 22 and Aug. 8 during the debt ceiling impasse in 2011, which was “perhaps the closest brush the United States has had” with default, according to a note published Thursday by Wells Fargo Economics.

And it wasn’t just stocks… From July 22 to August 8, 2011:

  • The S&P 500 plunged almost 17%, and the Dow 15%
  • Individual blue-chip stocks lost as much as 26%
  • Borrowing costs soared
  • During that same time period the price of gold rose almost 15%

That’s probably because tangible, physical gold and silver are historic safe haven assets – exactly the thing everyone wants during periods uncertainty, and want even more during the worst economic turmoil.

I sincerely hope the debt ceiling stand-off is resolved in a non-destructive manner. I hope the Freedom Caucus is able to twist enough arms to negotiate a balanced budget with a timeline for paying down the nation’s $31.4 trillion debt.

But I’m not counting on it. Real, physical gold and silver are my hedge, my financial insurance policy against catastrophes. Whether it’s a self-inflicted debt default or some other black swan event I haven’t even thought of. What’s yours?

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