The Worst Case Scenario By: Gabriel PotterMBA, AIFA® 2013.10.09

It has been more than a week since the government shutdown began and there doesn’t appear to be any change in the near future.  Again, the critical danger to the economy is not the current government shutdown because, despite the direct pain to veterans, tourists, mothers with children receiving WIC, and so on, previous shutdowns have had a minor effect to GDP growth and economic stability.  On the other hand, if we fail to raise the debt ceiling, all predictions are off the table and we will be sailing into uncharted waters.  For instance, when the US government last flirted with the debt ceiling in Summer 2011, US treasuries rallied, even though common sense suggested the potential of the government not paying its debts should have caused treasuries to feel less secure and fall in value.  As it turned out, worried investors reverted to previous habits:  when the markets are frightening, they bought what, historically, had been considered the safest asset – US Treasuries.  The markets represent the collective behavior of millions of irrational investors and they’ll continue to defy rational predictions. 

As we get closer to a potential debt ceiling breach, we’ve have to consider the options for the US Government.  Can the US Treasury prioritize debt payments to treasury bonds, arguing damage to our creditors would create irreparable harm to our ability to borrow money?  There is no publicly known mechanisms for prioritizing payments and, Morgan Stanley recently argued that there is no legal basis as well. Credit Suisse suggests the Treasury may collect revenues and pay debts on a first-come, first-served basis.  Given the US Constitution’s (specifically the 14th amendment) requirement that the “validity of public debt… shall not be questioned”, the administration might exercise fiat power to override congressional inaction; in other words, the President may simply direct the US Treasury to issue new debt, consequently, accept an impeachment challenge from Congress to determine the constitutionality of his actions.  (There are articles available from Columbia Law Review and the New York Times which describe this tactic, and its pros & cons, in detail.)

So, there’s no way to know how the markets will react if we breach a debt ceiling since they’ve acted unpredictably simply when we’ve threatened a breach.  Furthermore, there is no way to know what actions the government can take to address a debt ceiling breach.  The uncertainties continue to multiply, and so the markets have suffered for the past week; the damage will  probably accelerate until there is some finality on Capitol Hill.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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