US debt crisis: countdown to default

The whole US Debt crisis is confusing to most people. It is an incredibly dire situation and incredibly complicated. A lot of solutions are being tossed around, but some careful analysis reveals no solution will leave everyone financially unharmed. The debate rages around what action to take, meanwhile, the world sits uneasy as this “dooms day” of August 2nd ticks ever closer. But what is all of this about? Why August 2nd? Are we heading for another recession? Should I sell all my shares? Is <insert country here> fucked?

We’ve cut through all the bullshit and explained everything as clearly as possible.

Behold; Debt 101.

Click Here: The Realtime US Debt Clock

Divided government

The Republicans who control the House of Representatives in the US want less spending and taxing than Barack Obama and the Democrats do. Arriving at a compromise between the two parties was never going to be easy but the Republicans are using the threat of “US default” to get their way. This has escalated and publicised the confrontation in ways rarely seen in U.S. history.

For all those blaming Obama for this current crisis, there are two points: He inherited this mess as it was spiralling out of control thanks to Bush. He is also quite powerless to fix it until he convinces Congress. Congress owns the responsibility of all debts, spending and taxes. Not Barrack Obama, he is ‘merely’ the spokesperson for the people.

What is a debt ceiling?

The debt ceiling is a cap set by US Congress on the amount of debt the Government can legally borrow. Politicians agree to raise the debt ceiling every time they vote for a spending hike or tax cut so in reality arguing over the debt ceiling is essentially arguing over whether to pay the bills.

The US reached its debt ceiling on May 16th, 2011. It is now the end of July, with no resolution in sight. August 2nd is the deadline set when the US will run out of borrowed money: the government will no longer be able to pay what it owes. Whichever way you look at it, people will lose, big time. The question is, “which people”?

Countdown to US Default

What happens if the US defaults on it’s debts?

“While at midnight on August 2nd we don’t all turn into pumpkins we do as a country, lose our borrowing authority for the first time in our history. There is no escaping that. There are no off ramps. People keep looking for off ramps. They don’t exist.”Jay Carney

If the US decides to stop paying interest on it’s bonds for a few weeks, then a few scenarios might happen, which I will go through briefly. One scenario is that some countries that are owed money and rely on US paying it’s interest, would lose that money the longer the US defaults for. This would piss a lot of powerful countries off. However, this is the most unlikely scenario as it would result in the heaviest penalties.

The US could default temporarily, continue to pay off interest on its bonds, but the U.S. government would stop paying its bills to its own country. This means that hospitals that have treated Medicare patients, nursing homes that house Medicard recipients, military and civilian employees of the U.S. government — these and many others will be refused some or all of the money that is owed to them.

This is the more likely default scenario, which the Republicans would secretly love, as it would spell complete Armageddon for Obama’s Democratic government in power now.

It will also be a huge shock to the credit-worthiness of the United States. Through most of the 20th century, the U.S. government was the world’s safest risk. That would very suddenly no longer be true, prompting a search for new (and better-governed) safe havens to borrow from.

Bullish for some

Canada and Australia are such safe havens: While America’s triple-A bond rating has been called into question, Canada and Australia’s triple-A rating remains secure — meaning that these countries borrowing costs could dip below those of the United States. Despite anticipation of a US default, Australia’s dollar has broken a 28 year high of US$1.10.  If a U.S. default continues for any substantial length of time, nobody will escape the consequences, but if a default occurs on US internal repayments for a short time, Australia’s links to China will act as a buffer; China’s growth should be unaffected.

Bearish for most

If the US defaults for a very short time, a couple of days for example, it would make their national debt problem much worse. Interest rates would permanently rise. Their financial system would seize up temporarily, and a recession would certainly result from slashing government spending by 10 per cent of gross domestic product for more than a few weeks.

Who does the US owe?

If the US defaults for an extended period of time, the global economy is, quite frankly, fucked. The markets panicked when Greece, a country with GDP of $US330 billion, was close to defaulting – you will soon see the fallout as a country with a $US14 trillion economy comes close. Right now, economies are trading keeping their fingers crossed on the belief that this is a most unlikely scenario. Everyone believes they can pay their debts. If they default, it will be perceived that they “decided” to default, rather than had no other choice. The US is well aware of where it stands with other nations. …Surely?

The U.S. government is the largest purchaser of goods and services on the planet. If it abruptly ceases paying for its purchasers, the shock will cascade through the global economy in the following ways:

Paying some bills and not others

The U.S. government does not pay its suppliers, those suppliers won’t be able to pay suppliers of their own – which would trigger supplier defaults on their own financial obligations sparking another U.S. and international banking crisis. It would be 2008 all over again.

If unpaid U.S. government suppliers lay off workers, unemployment would rise again. It is currently at 9.2%, was at it’s highest at 10.1% in November 2009 in recent times. That was not far off the highest unemployment rate in US history of 10.8% back in 1982. Unemployed workers drastically cut back on their own purchases, especially purchases from overseas.

US Unemployment Rates

If the cutback in U.S. government activity slows overall U.S. economic growth (already slowed by the rise in energy prices this year), the rest of the world who export to the US will feel the pain. China, Japan, next door neighbour Canada will all have their economies retarded significantly.

Solution 1: Cut back US spending!

Pretty obvious right? Wrong. Balancing the budget immediately would be a catastrophe.

It is simple arithmetic: What the government spends becomes someone’s income, which they in turn can spend. Cutting government spending (or raising taxes) means cutting disposable income, and that means cutting economic growth. The US needs at least a couple more years of strong economic recovery before it can comfortably absorb large budget cuts.

Cost of not Raising The Debt Ceiling

Solution 2: Print more money, pay the debts!

The US central bank could buy up the government bonds that are about to mature, using newly created money.

When a nation prints more money, it effectively starts to spend more money than it makes. This puts pressure on the economy to step up and produce more wealth. Otherwise, what happens when that “created” money runs out and the nation is left making the same amount of “real” money that it was before? You can’t just keep printing more money. This has the effect of “hyperinflation”, ie: the economy raises prices for everything to account for there suddenly being several trillion dollars extra, effectively floating around in people’s pockets.

Printing money is, to put it simply, “fake” wealth that a country can’t sustain, like giving a gambling addict a thousand dollars. Once the splurge ends, you’re likely worse off than before, that is unless you use that cash to create more long-term wealth to sustain yourself when it inevitably runs out.

Risky business.

Post-default hope

Countries have defaulted before, lost their triple-A rating and managed to recover and even return to the markets for loans.

Americans are not currently overtaxed. Not even near it, historically speaking, or compared to the likes of Australians. It’s a tricky balancing act, which we have seen right here on our own Australian shores with the redistribution of wealth and taxes to different income groups. It all forms part of the strengthening of the economy vs. the essential repaying of government loans.

Sources:

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Categories: Business, Politics, Law

Author:Andrew Beato

CEO, Chief Editor and founder of Intentious. Passionate comment enthusiast, amateur philosopher, Quora contributor, audiobook and general knowledge addict.

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3 Comments on “US debt crisis: countdown to default”

  1. Mark
    July 28, 2011 at 9:51 pm #

    Excellent article!

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