16 October 2013

Government Default = Black Thursday?

Last week I published a short article on the effects of the Government Shutdown. Today I’ll explain what will happen on Thursday 17th October if congress does not raise the United States of America’s debt ceiling.

Like many other countries (including Malta) the US collects less money than it spends. This has been happening for many years. The US government’s main source of income is federal taxes while its spectrum of spending is wide. Food stamps, Medicaid, the military and the 2.65 million who are employed by the federal government are examples of where income tax money is distributed internally. The US also pays out billions in financial aid to counties such as Egypt, Israel, Pakistan, Mexico, Nigeria, the Philippines and another 25 countries for “good behaviour”, “good friendship” or military bases. The US is a major contributor to the United Nations, NATO and other international bodies.

Being the most indebted country in the world, the US pays a lot of money in interest on its debt. According to the US Treasury website (http://www.treasurydirect.gov/govt/reports/ir/ir_expense.htm) more than $415 billion was paid in interest between September 2012 and October 2013.

In order for the government to borrow more money it needs the approval of congress. If congress does not approve this increase the government will run out of money.

Let us imagine that the US government is a person. This person has a family to support. He has a wallet, a bank account, a credit card and a loan. The bank accounts stand at zero, the credit cards are maxed out and a loan payment is due. His wallet is bone dry. This person has a job but the pay cheque will not cover the expenses.

Now think of congress as the Bank that can approve an increase in this person’s loan facilities. If the loan ceiling is increased the person can cover the additional expenses. If not, …

If the US were to default, the financial markets will probably react very badly and we could risk facing another Black day in which stock exchanges spiral out of control as investors see this uncertainty as a sign to pull out of certain markets. Another effect of a default would probably be that rating agencies downgrade the US. This will result in an increase in borrowing costs. Simply put, instead of paying $415 billion in interest the government would have to pay $800 billion for the same amount of money. This is because investors no longer see the US government as a safe place to invest their money and will demand more interest. It is like having negative notches on your credit rating. Once this happens banks will no longer want to loan money and you would have to go to a pay-day lender or, even worse, a loan shark.

A default would result in a weaker dollar. Since most international business is conducted in this currency, countries who already committed to transact in this currency will suffer because of this unexpected change.

Hopefully the President and Congress see sense before damage is done.

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