A week ago, we were all worrying about Europe going bust.
Last Thursday’s deal has put that scenario back on the back burner – for a couple of weeks, at least.
But the markets seem to need something to worry about, so attention has now turned to the US.
No one truly believes it will default on its debt, but doubts are clearly creeping in.
Stock markets are sliding. Gold is soaring. US Treasury yields are hardly spiking, but they’re showing signs of concern.
So what’s the problem? Is the US really likely to default? And what does it mean for you?
Only in America
Here’s the funny thing about this US default panic: it really could only happen in America. Yes, the US finances are in a terrible state. And in the long run, it’s on a road to disaster. But that’s not the reason for the current panic.
The reason this is happening now, is because the US – uniquely – has this artificial, self-imposed debt ceiling. This is a legal cap on the amount of money the US government can borrow to fund itself.
Before 1917, politicians authorised the US Treasury to issue bonds for specific purposes, as a Washington Post primer by Ezra Klein and Dylan Matthews points out.
But that meant every bond had to be approved separately. The rules were relaxed to help fund World War I (just in passing, it’s worth noting here that monetary debasement and rising taxes very often stem from the need or desire to wage war). By 1939, the debt ceiling was a general limit on all debt, rather than specific bonds.
The ceiling is currently set at $14.3 trillion. The Treasury will have run out of headroom by around 2 August. “Because spending currently exceeds revenues by almost 45%, if that happens, [the US] will either have to default on [its] debt or stop funding a substantial portion of the government.”
That would mean slashing most public services. And that would have a big impact on the economy. Regardless of your views on how big the government should or should not be, a short-term, large-scale shutdown like that would not be good news for growth or stability.
So why not just raise the debt ceiling? That’s what normally happens. Indeed, it’s why the ceiling is an entirely pointless limit most of the time. It’s been raised 90-odd times since it was introduced. It’s hardly acted as a limit on big government.
This is all about the 2012 US election
But this time, the guys in charge (Barack Obama and the Democrats) don’t actually have enough control over the government to push this through. And so the Republicans are milking this political vulnerability for all they’re worth.
The main thing you have to remember about the debt ceiling shenanigans is this: next year is election year in the US. So politicians are looking to score points at every opportunity they get. And this is the perfect issue to take a stand on.
Remember, this is the battleground on which Britain’s last election was fought. Should we cut now? Or cut later? Which party will be the most responsible custodian of the economy? The same scenario is playing out in the US right now.
The latest deals on the table are as follows. The Democrats want to raise the debt ceiling in one move, which would take them past the 2012 election. This deal would be accompanied by $2,700 bn ($2.7 trillion) in spending cuts.
The Republicans want the debt ceiling raised by around $1,000bn (a trillion). But they then want another vote on the debt ceiling in six months’ time, with deeper spending cuts pushed through.
In other words, the Republicans want to make sure they can force another vote before the election. That would enable them to accuse the Democrats of being ridiculous spendthrifts who can’t be trusted with the reins of the economy.
The Democrats on the other hand, want to portray themselves as the party of reason. They are just trying to do a deal that will keep the show on the road. But these rabid Republican fanatics are instead happy to “allow the American people to become collateral damage to Washington’s political warfare”, as Obama himself put it.
Now I’m not taking sides here. I don’t follow US politics closely enough to get into the minutiae of who said what to whom, and whose fault this all is in the first place. Lord knows we have enough drama queens screaming for attention in Parliament on this side of the Atlantic without having to endure the antics of another bunch over there.
My gut feeling is that there will be a compromise deal. It’s in the Republican’s interests to make one. Because they’ll end up taking the blame for the resulting financial market turmoil if the US does actually default for any period of time.
What does this mean for investors?
What if no deal is struck? The precise consequences depend on how a default would play out. We’ll go into them in more detail in the next week or so if it looks like this scenario will actually arise. And I’d take the 2 August deadline with a pinch of salt. Various reports from investment banks suggest there is breathing room up to at least 8 August, if not longer.
But the short answer is, hold on to gold. If you’ve been reading MoneyWeek magazine, or Money Morning for any length of time, you probably already do. And if you do own gold, you’re laughing. With both the dollar and the euro in trouble, and the Swiss franc looking very expensive indeed, it’s one of the few safe havens left on the planet. Hang on to it. If the US genuinely defaults,the sky would be the limit. See here for the chart of the gold price gold vs the debt ceiling.
I don’t believe the US will default. And I’d expect a relief rally in the dollar and probably a ‘relief’ drop in gold if and when a deal is done. But it’ll still be worth holding on to gold. After all, if the debt ceiling is raised, it just gives the government even more rope to hang itself with in the long run.
Our recommended article for today
Ten of the best books on economics
As the holiday season gets under way, Merryn Somerset Webb looks forward to relaxing on the beach with with a good read. Here, she picks her top ten books on economics.
• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .