Updated: 7/25/2011 2:57 PM ET|
How a US default could hurt you
If the government fails to raise its borrowing limit by Aug. 2, the impact on consumers could be deep and wide-ranging, from rising interest rates to a stock market sell-off.
Ask Jay Powell how the average consumer would be affected if Congress doesn't vote to raise the debt ceiling before Aug. 2, and he responds with his own question:
"Did that consumer lose his job?"
That's a good possibility if the consumer happens to work for the federal government, for a defense contractor that doesn't get paid or for a company that needs credit to keep going.
It could also be big trouble for anyone who needs a car, needs a home or student loan, uses a credit card, has a retirement savings account or wants to travel abroad.
Not raising the limit on how much the U.S. government can borrow -- now set at $14.3 trillion -- would be "an enormous economic event," said Powell, who was undersecretary of the Treasury for the first President Bush and now works at the Bipartisan Policy Center, a Washington, D.C., think tank. He is an author of the center's analysis of the debt-limit situation (.pdf file).
The analysis estimates that without authorization to borrow, the federal government would take in about $203 billion in revenue but have $362 billion in bills to pay.
So choices would have to be made on what got paid. Interest on outstanding debt would take priority to avoid default and damage to the U.S. credit rating. Beyond that, should the government pay Social Security benefits but not the salaries of servicemen and servicewomen on active duty? Medicare and Medicaid payments but not federal workers' salaries and benefits?
The U.S. government has 80 million bills due in August, and, no matter what choices are made, about 40% to 45% of them won't get paid unless more borrowing is authorized.
"When you take away all that spending, it will have a huge effect on the broader economy," Powell said.
Impact on interest rates
And if the U.S. government doesn't pay back the $500 billion in debts coming due in August -- or at least pay the $29 billion in interest on those loans -- that default is going to cause havoc in the economy's credit sector, which will eventually reach down to anyone who needs to borrow money or uses a credit card.
How much interest is charged on a loan is determined by an assessment of the chances of the money being repaid. Lending money to the U.S. government, by buying Treasury bonds, has been rated as one of most risk-free investments available, which means the government pays a small amount of interest on the money borrowed.
Moody's Investors Service, Standard & Poor's and Fitch have said that a default would prompt them to downgrade the United States' credit rating from the top-ranked Aaa. But simply raising the debt ceiling, without getting the nation's debt problems under control, might not be enough to prevent a downgrade, the ratings agencies have indicated.
Treasury bonds provide the floor for other lending -- car and home loans, credit card debt and student loans, for instance. And because those loans are seen as more risky, the interest charged on them is higher and could rise faster than an increase in the rate on U.S. securities.
How much those interest rates might go up would depend to a large extent on perception, said John Praveen, the managing director of Prudential International Investment Advisers in Newark, N.J.
"It's not so much how much but how fast" interest rates change, he said.
For example, if the rate on 10-year Treasury bills went up half a percentage point, Praveen doesn't think there would be much impact, since the rate is low already (3% to 3.5%). But if the rate increased quickly by 1 or 2 points, the perception in the equity markets would be that the rate would keep going up.
"There would be uncertainty because you don't know if the increase will continue; you don't know the endgame," Praveen said.
A 1% spike could cause problems. For example, Praveen said that given the high correlation between mortgage rates and the Treasury yields, homebuyers could expect a one-to-one increase in mortgage rates.
A worst-case scenario
Other negative effects could include a sell-off in the equity markets, which could hit retirement accounts hard. Banks could stop lending to each other and to consumers, preferring to hang on to assets rather than risk them by lending. A sharp decrease in spending by wary consumers could mean that the economy, weak already, could falter further. All of these scenarios, Praveen said, could build on themselves, and the snowball effect could send the economy back into recession.
It is this "fear factor" that Praveen sees as having the most potential for damage.
Praveen was quick to point out that this would be a worst-case scenario he saw as highly unlikely. He predicted that the nation's leaders will stop acting like "little children" and that an agreement will be reached to raise the debt ceiling. Even if that does not happen by Aug. 2, Praveen said he expects an agreement within a couple of days after that date.
"A short shutdown would not mean a lasting event," he said. "There would be a one- to two-day sell-off in the markets, and that's it, before things start getting back to normal."
Again, perception would be key -- in this case, perception of how long a government shutdown would last, of how long it would be before some agreement is reached on spending and/or borrowing.
"We'd be living at the four-way intersection of finance, politics, symbolism and psychology," said Paul Palazzo, the managing director of financial planning at Altfest Personal Wealth Management in New York. "A default would almost certainly result in higher uncertainty and anxiety, none of which is generally good for consumer confidence. But there doesn't have to be lasting damage. . . . In an uncertain environment, the movement of money could well slow down. But again, the question is, What time frame are we talking about -- days, weeks, months?"
Powell, of the Bipartisan Policy Center, told CBS News last week that even a short shutdown could cause a "lasting blemish" on the U.S. credit record, making future borrowing more costly for the U.S. government and resulting in more debt for taxpayers to repay. But Powell and Praveen agreed that any negative effect on the U.S. dollar's value would be cushioned by the debt crisis in Europe.
"The euro is already weakening," Praveen said, "and with two currencies in weakening trends, you could see strengthening of some other currencies -- the Japanese yen, for instance."
A weaker dollar makes U.S. goods cheaper, but Praveen points out that the benefits to U.S. exporting would be muted. "Even if U.S. goods are cheaper, with a general recession worldwide, then who's going to buy?" he asked.
Because the dollar is unlikely to weaken against the euro, trips to Europe may not become more expensive. However, Praveen said, some currencies could get stronger against the dollar, and trips to Asia, Brazil, Canada and Mexico would become more expensive.
"That may lead some Americans to cancel their summer trips abroad or spend less when they travel," he said.
Another effect of a weakened dollar would be that goods imported to the U.S. would not be as cheap as they are now. That could include items from China, although Praveen said there's a caveat there. The Chinese currency is controlled by the Chinese central bank, which might choose to keep the exchange rate intact so that Chinese goods remained attractive to U.S. consumers.
What should investors do?
Despite all the potential negative consequences of not raising the borrowing limit or reducing federal spending, Altfest's Palazzo is telling his clients there wouldn't have to be fundamental damage to the economy.
"We are telling clients to stay the course," he said. "It is true that if the situation isn't resolved, markets could go down. It's also true that if it is resolved, they could go up. . . . We believe portfolios should be designed for the long term, in a way that enables clients to withstand the fluctuations that come along the way."
Estimates of retirement-account losses in 2008 range from 22% to 33%. But that incoming wave of the recession might have served as a warning to retirees to adjust the holdings in their accounts to protect against another dip. Losses in individual accounts because of a U.S. borrowing crisis would depend on the structure of those accounts -- how much was invested in stocks, credit instruments and other holdings.
An advisory to clients issued this week at Merriman, a financial-planning company based in Seattle, had much the same advice as Palazzo's, noting that "despite a subsequent worldwide major economic crisis, and with continuing worries about the anemic recovery, sovereign debt and the U.S. deficits, most of our composites are above their previous October 2007 high."
The advice to clients was to:
- Keep some cash on hand for emergencies.
- Maintain a well-balanced and thoroughly diversified portfolio.
- Rebalance your portfolio periodically.
Perhaps the bigger threat to the economy is the psychological factor that would be operating if the debt ceiling isn't raised.
"If people didn't get their Social Security checks, that would not be good," Palazzo said. "If people felt that government had become so dysfunctional that it couldn't carry out day-to-day responsibilities, then the symbolism could potentially be a lot more damaging in the long term than a missed check."
At least one consumer has suggested a way to use that symbolism -- along with some real consequences -- to bring an end to the wrangling over the debt ceiling. Pamela Clair of Toledo, Ohio, posted this suggestion to friends on her Facebook page and asked them to pass it on:
"Instead of threatening to withhold Social Security payments of people who really need the money, let's hold the paychecks of all House and Senate members, then see how fast it is resolved!"
Clair hopes her mini-movement will get the message across to higher-ups.
By Aug. 2? We'll see.
VIDEO ON MSN MONEY
I'm an average American on a fixed income. As many others do, I have had to cut back on any extras and a lot of necessities. Most of us do not understand why the Federal Government cannot do the same. There are many give-aways that could be stopped before threatening the military, federal worker and (especially) the Social Security payments.
Why are those give-aways still being funded?
For instance; the President is reported to have authorized funds to the National Endowment of the Arts and The Nation Endowment For the Arts just this last week. (Yes, TWO entities) If true, he is not doing anything to help the debt talks move forward by that kind of action. His "change" champaign promises have amounted to more and more and more of the same...not restraint.
It's way past time for the finger-pointing to stop and a solution to be reached.
I think its time we put all this republican and democrat crap away. This is the most important current crisis this country is facing. Playing politics with it, I think, is completely unacceptable.
Our government, for the first time, has to face facts. Our government needs to be run like a for-profit business. I.E....Dont spend more than you take in. Pay your bills...etc.
If you look back into the history. Its my belief that our problems started when the only people running for political office became the LAWYER. Its been said, you have to question the motives of anyone spending millions of dollars to get elected to a job that only pays a few hundred thousand a year.
Like Reagan said, Government IS THE PROBLEM. The only long term fix I see for this country is Congressional Term Limits. Right now, there are congressman in office that were first elected to office when Truman was president. Congress is unwilling and incapable of policing itself. There needs to be a national election by the people where the congressional term limit is set. I think two terms as a congressman and your done is a great idea :) Professional Congressional Lobbying should be illegal. You want to get the "fat cats" and special interest out of the government, thats the way to do it.
What people now call "campaign contributions" they used to call bribery. We the people need to fix this problem. This is no longer an academic exercise, its life or death as a nation.
The government has to change fundamentally how it operates. When I was in the Federal Government, If an agency got their annual budget, they had to spend ALL of it or their budget next year would be less, based on how much they spent the previous year. How INSANE is that!
I think federal agencies should be allowed to hold the money they are alloted, if they dont spend it.
It my opinion, that there are competing and destructive factions within our government that are fighting for the "hearts and minds" of our elected leadership. Fundamental belief systems like; progressivism, socialism, etc. History will show you that none of these have ever worked.
If you want to stand in line for hours for bread....choose socialism. Class warfare, re-distribution of wealth, "whats fair", "money is evil", "i'm entitled" or "I deserve", are all socialist beliefs.
What has made this country great is; hard work, determination, GOD, personal FREEDOM, freedom of speech...etc. Our Constitution is not optional.
I have spent my entire adult life "on the line". This is the greatest nation this world has ever known. The people who dont like it, either want to be absolute ruler or have never been outside the country. Wake up and VOTE.
Also another way to get elected into office, offer to have your retirement , benefits and salaries downgraded to the same level as the other working class. No more voting themselves a raise. No more collective bargaining.
Wow, I am really shocked at how much of our country is running on borrowed money. I knew about SS and Medicare, but to know that even military, personal loans, credit cards, etc will be affected is really unbelievable. Think about this for a minute... The government is always telling us to "be frugal with your credit card and debt," yet they have signed our name and made us all responsible for a huge debt with world-wide consequences. It's like opening a business in your spouse's name and then expanding, hiring new employees, buying new buildings, and living the life of the rich and famous - all on their credit. To make matters worse, they have moved all our tangible money-making prospects overseas. We produce practically nothing here so we have very limited ways of ever paying this money back and very little leverage in the world-wide market.
It's just mind-boggling how our politicians, the people we rely on to make good decisions for us, have thrown our country under the bus.
Make it a flat 10% income tax rate across the board for everyone, if you make $2,000,000.00 million a year you pay 10%, if you make $20,000.00 a year you pay 10% its fair for everyone, forget all the loop hole write offs that the rich get away with.
Canada has had a 10% for years and it has worked for them, (better than what we have (that's why they all come here because they can afford to come her on vacation and have second homes etc. I can't afford to pay attention let alone a second home or even a vacation) the 10% also works for Mexico and other countries.
I've lost all faith in our government.They now expect our great grandchildren to pay for our spending spree,and these elected officials still want to keep spending.
Big business..the banks..and the military industrial complex are bleeding us dry.
Fire the government..we need a fresh start.
Keeping the masses Suppressed and Depressed isn't what our Founding Fathers had in mind !!
We need you to wake up and shake up! Stop sending BILLIONS over seas to countries that loathe us and spend their waking hours planning to destroy us! Close our borders and bring our troops home. Open our oil fields and for God's sake...Take care of " US" first and foremost...
Looking forward to a brighter future.
We listened to both President Obama and Speaker Boehner last night and have come to the conclusion that the talks that transpired in the white house between these two men needed to be broadcast. Then the american public could make up their minds about who was being unreasonable. In our opinion, it appears that the republicans want everything their way. Still though, to actually see and hear those talks could only be beneficial to the public.
There are many ways to save money, and politicians flying first class from their home states to D.C. is one way of doing that. Plus the waiting limo and driver at the airport to take them to their job is another. They must think they are royalty. I know it isn't trillions of dollars, however, it's a start. Let's quit trying to take things away from the poor and middle class and get down to where the real money could be saved. That would be the tax breaks for the rich.
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