Lost in the nonsense that is currently passing for debate in the Congress, is the fact that the current size of our national debt ($16 Trillion) is due, NOT to the size our annual budget, but due to the inordinate debt run up to pay for the Mideast wars, the bailout of the banking industry in 2008, and the stimulus package in 2009. Compounding the issue is the Bush tax cuts that reduced current government revenue and pushed us further into debt.

These are NOT annually recurring events that will be fixed by gutting current government spending. Most of this debt is in the form of Treasury bonds held largely by foreign governments. We must be able to pay the interest on these bonds from current tax revenue. By gutting current government spending and hence reducing money flow into the economy we reduce profits and therefore reduce tax revenue. It is like telling someone who has accumulated a huge credit card debt, that the best way to pay it off is to stop buying food. You must be able to function in the present to pay off the debts accumulated in the past.

Since there appears to be a real possibility of the House refusing to compromise, we must look at several very serious consequences of default.

  • A cornerstone of the banking industry is the ability of banks to loan money to one another overnight. These are called “repo” loans and are collateralized by short term Treasuries. If the Government defaults this function will collapse as banks are not allowed to hold defaulted securities. This has NEVER HAPPENED BEFORE SO WE HAVE NO IDEA WHAT WILL RESULT.
  • It is likely that enormous amounts of money have been wagered in the derivative market on whether the government will default or not. My concern about the derivative market is at “red alert” stage due to the lack of regulation or transparency and the sheer size of the market. Whichever way the shoe falls, billions of dollars will be owed immediately by the losers since derivative debts are not collateralized. The last time this happened was September of 2008 and the government had to bail out the losers, which is unlikely to happen again.

The recurring theme of the times, whether it is storms or political dysfunction, is that “we have never been here before”.

I continue to draw the comparison to the times many of us grew up in where we had the threat of nuclear war hanging over our heads. This is nowhere near a disaster of that dimension.  So sleep well and hope that cooler heads prevail. John Authors put it best in his “The Long View” column in Financial Times:

“For now, there remains a risk that stupidity will prevail.  While that risk remains, managing money is hard.  Investors who complain about politicians are fully entitled to do so.”