What will happen if Uncle Sam does not raise the debt ceiling?

July 27th, 2011

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Today, the financial markets are abuzz with chatter about the possible default of the US government due to Congress not raising the debt ceiling. A lot of investors are also interested in this topic and hence, this article.

First, what do we think will happen? We do not know what will happen in future. But our bet is that the debt ceiling will eventually be raised. If not by August 2, then it will be soon after. Maybe that will involve Obama invoking the 14th amendment clause in the Constitution to bypass Congress to raise the debt ceiling. Or maybe some other measures that we have not thought off. Or maybe there will be a surprise hugs and kisses in Congress as both Democrats and Republicans agree to raise the ceiling. Maybe… Anyway, this is not the first time this is happening. Every time, the debt ceiling is eventually raised. But because it was always raised eventually, it becomes like a game of crying wolf. So, each time it happens, the brinkmanship has to bring the country nearer to the edge in order to be taken more seriously.

But what if the unthinkable happens? What if the Uncle Sam fails to raise the debt ceiling and defaults on its debt?

US government debt is supposed to be the safest forms of cash in the world. It is supposed to be the debt that can never ever be defaulted. As a result, the yields on long-term US government debt become the benchmark to appraise every other investment, including stocks and bonds. The heart of value investing depends on the sacred safety of US government debt (see our series, Value investing for dummies). Now, there is talk that the US government may default on its debt. The fact that such a talk exists shows that it can happen. It hasn?t happen yet. But you can be sure that if it happens, it will throw chaos into the world of investing because if the world?s safest form of cash becomes unsafe, how do you value all the other investments?

So, what will happen?

Obviously, the US dollar will go down. But go down relative to which currency? Euros? Nay, Europe has its own sovereign debt problems. Yen? Maybe yes, but Japan?s government debt as a percentage of GDP dwarfs even the Greeks. Chinese Yuan? Perhaps, but it is still not a fully convertible currency. Australian dollar? That sounds better, and that can explains why the AUD is surging. Gold and silver? Yes, if the sacred safety of Uncle Sam?s debt is no longer safe, then there?s no recourse but to return to what is historically money for thousands of years.

Next, what will happen to interest rates in the US? Imagine all the US government bond holders heading for the exits together. US government bond prices will tank, which means its yields will surge. That will then lead to surging borrowing rates in the US.

But wait! Will Ben Bernanke sit there and do nothing while interest rates sky-rocket? Of course not! We think the Federal Reserve will step in by conjuring up money from thin air to buy the bonds from the panicking herd in order to support US government bond prices. And Bernanke will surely be praying that this will turn the tide of the massive wave of selling. What if the herd saw Bernanke?s money printing and believes that he is going to unleash a tidal wave of money into economy. That?ll be hyperinflationary! But if Bernanke does not do what it takes to support the US government bond prices, it will be hyperdeflationary as the already weak US economy get crunched by oppressively high interest rates.

Remember two years ago when National Party Barnaby Joyce suggested that Australia must have a contingency plan for an US government debt default. The then Prime Minister Rudd denounced him as an irresponsible loony. Today, that loony looks to be saner than Rudd.

Interesting times lies ahead. Those who had read our book, How to buy and invest in physical gold and silver bullion and had already taken action have much less to fear. And by the way, our book is now also available in iTunes, for those who owns Apple’s iPod Touch, iPhone and iPad.

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  • Hermit

    Are there any statistics on who owns US treasury notes? How much is owned by, say, China, Japan, Europe, etc? And how much is held by the Fed, US banks, investors, etc.? Given QE1 and QE2, I’m curious as to whether the share held by the Fed has increased, and if so, by how much.

  • What if, one day, the US increases it’s debt ceiling but folks refuse to purchase their new bonds? I assume they’ll have to default then anyhow but not sure how likely this senario is.

    What about the a US default having an affect on interest rates here? Possible?

  • The Federal Reserve information can be found at http://www.federalreserve.gov/releases/h41/Current/

    The rest can be quite tricky a laborious to gather.

  • It’s only a matter of time that folks will no longer buy their debt. But that’s a matter too far away for politicians to even think about.

    If US default results in hyperinflation, which in turn ignite gold, silver and commodity prices, it can trigger price inflation in Australia. That may prompt the RBA to raise rates.

  • Kamaljit

    Here?s a quick and fascinating breakdown by total amount held and percentage of total U.S. debt, according to Business Insider:
    Social Security trust fund:?$2.67 trillion (19 percent)
    The U.S. Treasury:?$1.63 trillion (11.3 percent)
    China:?$1.16 trillion (8 percent)
    U.S. households:?$959.4 billion (6.6 percent)
    Japan:?$912.4 billion (6.4 percent)
    State and local governments:?$506.1 billion (3.5 percent)
    Private pension funds:?$504.7 billion (3.5 percent)
    United Kingdom:?$346.5 billion (2.4 percent)
    Money market mutual funds:?$337.7 billion (2.4 percent)
    State, local and federal retirement funds:?$320.9 billion (2.2 percent)
    Commercial banks:?$301.8 billion (2.1 percent)
    Mutual funds: $300.5 billion (2 percent)
    Oil exporting countries: $229.8 billion (1.6 percent)
    Brazil: $211.4 billion (1.5 percent)
    Taiwan: $153.4 billion (1.1 percent)
    Caribbean banking centers: $148.3 (1 percent)
    Hong Kong: $121.9 billion (0.9 percent)

  • Hermit

    Very interesting. Do you have a link to the original source?

  • Hermit

    Never mind, I found it!

    Thanks for the tip.

  • Kamaljit

    You are welcome. Btw, if you did take a call, today would you long or short the eur/usd.

  • Hermit

    I’d probably favour the Euro. In part because there seems to be a greater emphasis on austerity measures to claw back debt and partly because Europe is less consumer driven/more export orientated?than the US. Also, money supply growth in Europe is relatively constrained compared to the US.

  • Kamaljit

    Fair thought. Good thinker!

  • PeterCare

    Europe is not a homogenous region. Yes it’s true that Germany and to a lesser extent France and Sweden are export driven, but other parts are very much consumer driven (Italy,Spain, Greece for example). It’s not that simple to analyse Europe.