Deconstructing the debt crisis: What it means to investors large and small

Recent Congressional proceedings over the federal debt ceiling have caused considerable concern on Wall Street. The concern emanates from the potential for a default by the U.S. government should the debt ceiling not be raised. Here are a few factors contributing to the concern:

First, the U.S. Treasury issues debt to fund a portion of the federal government’s rising expenditures and to refund maturing debt. A limit set by Congress now caps federal debt at $14.3 trillion. This limit must be raised in order for the government to issue more debt to meet rising expenditures, otherwise the government could default on its financial obligations.

Next, trillions of dollars of U.S. Treasury securities are held throughout the world by individuals, sovereign governments, and institutions that rely on our debt as a virtually risk free, highly liquid investment. Should the U.S. default on its payment obligations, it could result in fairly widespread selling of U.S. Treasury securities, disruption of global bond and credit markets, and rising interest rates.

Finally, as the world’s major reserve currency, the U.S. dollar is used to conduct billions of dollars of global trade transactions every day. If the safety of U.S. Treasury securities and U.S. dollar were called into question because of a default, it could cause significant disruption to global capital and trade flows which would negatively impact global economy activity.

The U.S. has never defaulted on its debt, so there is no precedent. That said, we believe the financial implications of a U.S. default could be significant and severe. Certain investors could be forced to sell their Treasury securities, driving interest rates up throughout the entire fixed income markets. The value of the dollar would decline raising the risk of higher inflation. U.S. government spending would most likely be reduced, which could result in reductions in a broad spectrum of federal spending including entitlement programs, defense spending, and outlays to state and local governments. Companies could cut back capital spending and hiring due to rising interest rates. All of this could result in further slowing of economic growth or recession.

If the U.S. were to default on its debt, your investment portfolio would most likely take a hit, at least temporarily. With a rise in interest rates, the value of your bond holdings would decline, and driven by short-term disarray in the bond markets and concerns over the economy, we suspect the stock market could also drop significantly.

As of this writing (August 1), a deal to resolve the debt crisis appears to be in the works. A successful deal would be taken positively by the markets, however, our country still faces considerable hurdles relating to our fiscal health and government debt which need to be addressed in order for investors to feel more positive. This could weigh on the markets until these issues are more constructively addressed.

Is there any good news in all this? We believe a default or even a downgrade of U.S. debt rating would “shock” our country into fiscal spending discipline. Also, over the past 20 years a number of countries, including Canada and Australia, faced debt crises and were able to get their financial houses in order and moved on to be strong economies and currencies. So there are positives that can come out of this.

Robert E. Toomey, CFA is the Vice President, Research at S.R. Schill & Associates on Mercer Island.


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