What Will Happen if the Debt Ceiling Isn’t Raised?

All over the news, there is talk of default, jobs lost, interest rates soaring, and general pandemonium.  There is certainly a lot of fear, stoked by the White House, leaders from both parties, and the news media.  So what will happen to jobs, interest rates, entitlement programs, and 401k’s if the debt ceiling isn’t raised?

Let’s first take a look at the US budget:

Income:  $2.6 Trillion


Interest on debt:  $0.4 Trillion

Social Security:  $0.8 Trillion

Medicare/Medicaid:  $0.7 Trillion

Department of Defense:  $0.8 Trillion

Other Spending:  $1.1 Trillion

Total Spending:  $3.8 Trillion

Budget Deficit:  $1.2 Trillion

If the debt ceiling is not raised, the US would have $1.2 T less to spend than it is currently spending.  The President, as leader of the Executive Branch, would need to decide what gets paid and what does not if income is not sufficient to meet expenses and money could not be borrowed.

Looking at the numbers, it quickly becomes apparent that there will be no default on the debt, meaning that interest not be paid, unless the President decides to default on the debt for political reasons. Otherwise, because the interest amount is only $0.4 Trillion, the Government could continue making interest payments easily using current income.  Likewise, Social Security and Medicare/Medicaid could also be paid.

Almost all of the funding for the Department of Defense could be maintained as well, lacking only $0.1 Trillion or $100 billion dollars out of $800 Billion, or a little more than 10%.  This means that all of the troops could be paid and most of the research and development and acquisition programs could be continued.  Of course, this would mean that the other departments (State, Education, Justice, etc….) would get no funding, which is unlikely.  It is therefore likely that many of the acquisition programs would be suspended to allow the main functions of  the other departments to continue.   Unfortunately, the Executive Branch has yet to release a contingency plan, saying instead that they expect the situation to be resolved.

Based on the numbers, the following will likely be the result if the debt ceilig is not raised:

1) The interest on the debt would continue to be paid, so there would be no default.  It has been reported that while the White House has been issuing dire warnings about default, the President has been secretly telling the banks not to worry.

2) Social Security checks would continue to go out, and Medicare bills would largely be paid (although there may be some restrictions on some services).

3) The military would continue to be paid, although some contracts would be delayed and some non-vital functions might be cut.

4) There would likely be furloughs of large numbers of Federal employees and suspension of contracts.  If the debt ceiling were never raised, a permanent cut in the size of government would be needed – about 40%.

5) It is very likely non-critical functions like the National Parks would be suspended indefinitely.  It is also possible that they may be reopened but with large user fees.

6)  Activities such as highway construction might be delayed or extremely reduced.

While this would be rough on Federal workers and contractors, the effect on the stock and bond markets would likely not be significant.  There may be a bit of a sell off at first due to the uncertainty and the effects of the government no longer spending future revenues, but things would soon stabilize.  Investors should therefore do the following:

1)  If 401K/investment  assets are not needed for 10 years of more, leave things in place.  If possible, start building up cash from income to buy more shares on the way down.

2) If assets are needed within the next 10 years – for retirement, for example – start to sell off enough for needed funds.  Note that this is always the advice – stocks are not a safe place to store money when needed within the next 5-10 years due to market volatility.

3)  If inflation is a concern – which it may be if the government starts printing money to pay for debts – be sure to include foreign stocks and stocks in basic resources (oil, mining, basic materials, etc…) as a hedge against inflation.

4) If you are a Federal worker or contractor, or live off of research grants, it would be wise to build up a large emergency fund by delaying unneeded expenses.  This may also mean selling some stocks, but preferably outside of a retirement account since the penalties of using retirement assets before retirement are significant.

It is important to look beyond the political hype.  The news media and politicians are being very irresponsible with talk about default when there is no reason for a default even if the debt ceiling were not raised.  Investors need to look beyond the hype and stick with their plans.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Why Private Accounts Would Be So Much Better than the Current Social Security System

Wealth – a mass of things of value for which someone would be willing to trade or work for – is created through work.  It is also created through the extraction of natural resources.   If work is used to provide services (hair cuts, lawn mowing) or things that are used or destroyed (rock concerts, food), then the net wealth of society is fixed.  If you have a magic coin and I give you a haircut for that magic coin, after the haircut I now have the magic coin and in two weeks you no longer have a haircut, so the wealth of the world is still one magic coin.  I could also just club you over the head and take the magic coin without giving you the haircut and the net effect would be the same, although you would be less happy (just like with Social Security taxes).

Let’s say that instead of giving you a wasting asset like a haircut, I dig up some ore and create a knife and trade it for your magic coin.  As long as you take care of it, the knife will last indefinitely.  This time instead of the fruit of my labor decaying away, I have created wealth.  The wealth of the world is now doubled and worth two magic coins – one in the form of a knife, and one in the form of a magic coin.

Social Security in its present form, from a cash-flow perspective, is like me clubbing you over the head and taking your magic coin.  When you do work and I take it from you without providing anything of value in return (other than perhaps some nice stories about the good ol’ days), the amount of wealth in the world is decreased when I use up the result of your work (for example, the food you grew).  When you are ready to retire, if there is someone who is willing to allow you to take the result of his labor without immediate compensation, then you will be fed.  This can continue indefinitely so long as there are enough people still working, although there is only a certain amount that can be taken from the still working before they will stop working. This means that you may get just enough, or almost enough, but you won’t get a huge excess.  After all, the next guy needs to eat too.

The problem comes when you have a large bump in the population – the Baby Boom.  If you were to have those Boomers, while working, pay enough to pay for themselves and those currently retired, and you were to store the excess taken somehow until the large bump in the population retires, those coming after them would only need to provide as much as the generations before them provided since the additional revenue needed would be there in storage.

But the wealth, while taken, was not stored because Social Security is a pay-as-you-go system.  Extra revenue beyond what is needed to pay for current retirees was spent on other things – nuclear missiles, EPA studies, White House Dinners, trailers for hurricane victims, schools in Iraq, etc….  This means that as the Boomers are starting to retire, the amount of wealth being taken from those after them (Gen X) is not enough to provide the same level of benefits unless the amount being taken is increased.  This means that either the Boomers will see their benefits cut or the Gen Xers will need to provide far more than they get.  It probably will mean a little of each.  This is where we currently are.

But let’s say now that instead of me clubbing you over the head and taking your magic coin, I use my wealth to create things of value – say a knife or a table – and then store them until I retire.  Things that I can give you for your magic coin which you will gladly accept because they are useful and therefore valuable.  As I am selling my tables and knives to you for your magic coins, even though I use the magic coins up to sustain me, you still have the knives and tables which you can trade for magic coins from someone else when you are ready to retire.  No one needs to get clubbed over the head.

Now, instead of saving up tables or knives, let’s say that I trade my labor for interests in  corporations.  These things don’t only hold their value – they grow in value.  As the corporation starts to generate more revenue, by providing something that other people are willing to do work or trade something they have of value to obtain, the corporation  becomes more valuable.  The amount of wealth in the world is increased.  When I sell my shares of stock, I am not draining anything from those still working – I am trading something for something.  I am not just banking the wealth created by my labor – I am growing it.

And no, contrary to the myth currently being presented, it is not true that those who have invested in the stock market have only done about as well as the “investment” in Social Security or done worse.  They have done better – far better.  The return on stocks over the last 50 years has been over 10%, even with the 2000 and 2008 crashes.  The return on Social Security has been about 1%.  This is the difference between getting $10,000 per month in retirement and $10,000 per year.  (A more thorough analysis will come in a future post to show the difference.)

So, if we keep doing as we’re doing – clubbing the next generation over the head and stealing their magic coins, the ability to feed the current generation will always be dependent on the work of the next generation.  If too much of that work is expended for other purposes – for example for paying for wars or interest on debt – there will not be enough available to feed current retirees or the next generation will effectively become slaves with nothing to show for their labor.  If retirees instead have saved their work over their lifetimes for themselves, in things that have value, there will be no such dependency and both generations can enjoy the fruits of their own labor.

Risks and Rewards of Corporate Bonds

A bond is a loan made to a company (or government entity).  Just as with a house loan, the
loan is made for a specified period of time,  Unlike a house loan,
the loan is not repaid over time.  Instead, the company will pay a
fixed amount of interest on the loan during the period and then repay
the loan all at once at the end of the period. For example, a bond
with a par value (loan value) of 1000 and a coupon of 5% would
pay $50 per year, or $25 every six months.  When the bonds mature,
the person holding the bonds would be paid $1000 plus the final $25
interest payment.

During the life of the bond, it will be freely traded on the market and the price will
fluctuate.  An advantage is that one can make both interest and a
capital gain from bonds.  For example, if an investor bought the bond
listed above when it was trading for $500 and then held it to
maturity, he would receive both the interest payments , at an
effective rate of 10% for him, and $1000 when the bond matured.  He
would therefore make a $1000 capital gain.

While it varies by company and term, bonds are generally safer than bonds.  The reasons
are that the bond pays a fixed interest amount, meaning that a return
is generated even if stock prices are going nowhere, and no matter
what the price does, one can regain one’s investment by holding the
bonds until maturity.  As with anything, however, there are risks.
Here are the main risks of corporate bonds:

Default:  Obviously the primary risk with a bond is that the company that issues the bond
will be unable to pay and default on the bond.  When this occurs,
sometimes the company will issue shares fo stock to repay part of the
loan, sometimes the company will repay the loan but at a later date,
and sometimes the company will just default and not pay.  In general
when a company defaults on a bond the investor should expect to get
little or nothing back.

Interest Rate Rises:  Because bonds are primarily bought for the interest they pay they are
very sensitive to changes in interest rates.  For example, if banks
start paying higher interest rates, because a bank account is less
risky than a bond, many investors will sell their bonds and invest
their money in the bank.  Because of this, the price of bonds will
decrease, causing their interest rates they pay to increase (remember
that bond interest rates go in the opposite direction as the price of
the bond).  b]Buying bonds at periods like the present time, where
interest rates are rock bottom and only likely to go up, therefore is
especially risky.  On-the-other hand, buying bonds when interest
rates are very high and most likely to go down is a sound strategy.
As interest rates decrease the price of the bond will go up.  This
will provide income in addition to the relative high interest rate
that will be locked in when buying the bond.

Early Call:  If interest rates are sufficiently low many bonds will trade
above their par value. This is because investors will go to bonds in
order to increase the amount of interest they make when bank accounts
are paying nothing.  Many companies have call provisions that allow
then to repay the bonds early.  If interest rates are very low they
may well call the bonds, paying the par value, and then issue new
bonds at a lower rate.  this is much like a person refinancing their
home.  When this happens, if you’ve bought at above par value you
will lose the difference.

Your investing questions are wanted.  Please send to vtsioriginal@yahoo.comor leave in a comment.

Follow on Twitter to get news about new articles.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.