The U.S. Debt Ceiling and Investment ‘Safety’

The federal government spends money each year: our largest expenditures are Social Security, Medicare & Medicaid and defense. And each year the government takes in revenue, primarily through taxes. If the government spends more than it takes in – it typically does – then it must borrow the rest. The government borrows money by issuing bonds (“Treasuries”). Treasuries represent a debt owed: the holder of a Treasury loans money to the government and, in return, the government promises to repay the money at a later date, with interest. The “National Debt” represents the total of all outstanding debt, i.e. the amount the government has promised to repay over time.

Only Congress can borrow money on the credit of the United States. Originally, Congress authorized each individual debt. As you can imagine, this grew infeasible and, since 1917, Congress has instead established a limit on the total amount of debt the government can issue (the “Debt Ceiling”). As the National Debt has grown over time, Congress periodically raised the Debt Ceiling to allow the country to issue more Treasuries and fund its obligations. Traditionally, Congress viewed raising the ceiling as a procedural formality; it has raised the debt limit ten times since 2001 with little fanfare.

All that has changed. This year, Congress has thus far refused to raise the Debt Ceiling and, on May 16th, the United States reached its statutory debt limit. Through a series of emergency measures, the Treasury can continue to operate fully until about August 2nd. After then, the Treasury will not be able to fund all of our obligations. If nothing changes, there may not be sufficient funds for government expenditures like Social Security and Medicare. There may not be sufficient funds to repay the interest and principal on Treasuries. Furthermore, investors will likely no longer view United States debt as the safest investment available. The repercussions would be severe. Virtually all economists agree that a default would lead to an outcome somewhere between dismal and catastrophic.

What’s prompted the change? The answer is political, and we will attempt to remain agnostic regarding the political outcomes. We feel it fair to say, however, that some politicians, regardless of party affiliation, believe they can gain strategic advantage by threatening to refuse to raise the Debt Ceiling and defaulting on our National Debt.

Most debtors default for one of two reasons. First, they may not have the money available to pay. That is not our situation. At any time, our government can pay bondholders back by either raising more revenue (i.e. taxes) or issuing more debt. The second reason debtors default is the cost of servicing the debt becomes too high. Called an “economic default,” this situation arises when the costs of debt service outweigh the costs of default. In other words, sometimes it’s cheaper to declare bankruptcy and start over. Again, that situation doesn’t apply. Today our government can borrow at historically low rates. Moreover, a default will likely dramatically raise our future borrowing costs as lenders would demand a higher interest rate to compensate for the chance that we would again default on our obligations.

Will the United States default? In our opinion, no. Although politicians may have incentive to threaten default to exact concessions, they stand to gain nothing and lose a great deal if the country actually defaults on its obligations. We’ll find out shortly whether our prediction comes true, but when very powerful interests on both sides of a political issue strongly desire the same outcome, that outcome is almost a forgone conclusion.

If actual default is unlikely, what has people spooked? Investors worldwide have viewed US Treasuries as the safest investment possible. They relied on the combination of our giant economic engine and the government’s ability to, figuratively, print money. The United States should earn enough to pay off its debt over time and, even if it couldn’t, the government could pay bondholders anyway. The latter may cause inflation, but everyone gets paid back the face value of their bonds. That the United States would simply refuse to pay – even when it could – was unthinkable.

That “unthinkableness,” to coin a term, gets to the heart of why this debt-ceiling drama has shaken so many so greatly. Most of us spend time, money and energy protecting ourselves from unpleasant things: sickness, unemployment, theft, auto accidents and a host of others. And now something that we took for granted – the unquestionable safety of US bonds – no longer feels the same. The unthinkable has become the possible. It’s not exactly like learning that Santa Claus is a myth, but it takes us back to a very vulnerable place and prompts us to question our reality. If this can happen, what else?

The short answer is: almost anything can happen. We live in a complicated and uncertain world. This debt-ceiling episode has not changed anything. It simply reminds us that, regardless of our best efforts, bad things can and do happen. And despite all of our hard work and preparation, we still cannot predict with certainty what the future will bring.

What lessons can we draw from all this? First, there is a meaningful difference between “never” and “almost never.” People tend to treat very remote outcomes as impossible and, thus, fail to protect themselves properly. That’s why, at Wealth Architects, we consider liability protection an integral part of the wealth-management process. We help you identify potential financial risks and explore ways to insure against them. Proper liability management – insurance – helps protect against the unlikely or unknown.

Second, we need to refine our view of investment “safety.” Traditionally, investors seeking “safety” would find an asset that ostensibly provides great stability and load up on it. In the past 40 years, that “safe” investment has drifted from bonds to gold to stocks to real estate and back to bonds. But if you bought Treasuries in 1971, gold in 1980, stocks in 2000 or investment property in 2006 you got something very far from “safe.”

We instead believe that, over time, the “safest” investment is a well-diversified portfolio based on your unique financial goals. It’s true that, if we may borrow loosely from President Lincoln, you can’t protect all your money from all things all of the time. But a properly diversified, global portfolio provides exposure to the entire world’s capital markets – a thirty-five-trillion-dollar economic engine – and thousands of corporate and sovereign bonds. Such broad diversification provides “safety” in two ways. First, your financial success doesn’t rely on the success of any one company or country. Second, a well-constructed portfolio gives you the best chance, over time, to reach your financial goals. We feel that designing a portfolio to keep you on track to meet your goals, regardless of what bad things may come, provides the best kind of comfort and safety.

Originally Published July 2011.