Another Chance to Get it Right - The US Debt Ceiling

A deficit deal must be reached before the August 2nd deadline. In a press conference this morning, President Obama stated that he will meet with his budget team, Vice President Biden, and House Speaker Boehner. The US is in desperate need of a strict budget overhaul, and this could be its chance to do so. In an ideal, somehow unrealistic situation, the debt ceiling will remain and the US will agree to make the necessary cash adjustments to remain solvent in both the current and long term. The US needs a strict force to whip it into shape; the debt ceiling is that force.

White House officials, economists, and pundits in the media use scare words like catastrophic consequences, disaster, the end of the US - if the debt ceiling is not raised. President Obama even lashed out against those that disagreed with him on the debt ceiling issue as irresponsible. Laughable that the ones who were irresponsible are now clinging for political and economic survival. The blame game, and further dithering is not the heart of the matter, as some in the media cleverly make apparent. As daunting as it might be, the numbers deserve more light.

Keeping the debt ceiling at its current level will force us to make serious sacrifices, and operate within our limits, for once. Now is our chance to reverse the status-quo and allow the nation to freely grow without the strangles of debt and bad budgetary practice. Let's delve deeper into what's at stake.

US default is not as scary as the media makes it out to be. It's nowhere close to what Argentina experienced, or what we see now in Greece. The US simply does not have enough cash to cover its debt payments, which fuels the government machine behind the economy. There have been 16 consecutive occasions since 1993 in which the debt ceiling was raised. The decision to open up allow a little more debt to keep up with unsustainable government services adds up, and now we find ourselves at what should be the debt peak. The argument rests in the decision of whether or not to default on bond interest or the principle. We seldom hear of the debate to stay within the set limit and introduce a budget overhaul to correct the mistakes we clearly made after budget plan that came out of the previous debt ceiling lift. Now that's irresponsible.

Here's an option on the table. The not so scary default could be tamed if the Treasury department rolls over maturing issues, so long as the overall stock of outstanding debt does not rise. The term rollover means that the Treasury uses money from the sale of new T-Bills to fund the rollover of maturing debt. It's essentially replacing debt due with new debt, instead of paying for it in cash (which we don't have). The treasury already does this every Monday -- $30 billion worth of T-Bill due for payment are rolled over with the issuance of new debt. See the cycle? It's all virtual faith. The safe haven is made more of an idea every Monday, when the  underlying asset is clouded. The continuing pattern after the gold standard (in which every dollar was backed by gold).

According to ICAP data made public by The Economist, interest payments can be covered. In August of 2011 (the debt ceiling deadline), the US will have an estimated $185 billion in cash receipts, $37 billion in interest due, and $340 billion in other outlays, equating to a ($192 billion) deficit. If the government fixes its budget so that these outlays (which fund government services, bank transfers, bond payments, etc) decreases to allow cash to cover interest, we can avoid less harm. The Prompt Payment Act enforces penalties on late interest payments - yet another expense to worry about. This is a clearly unbalanced position, and the ICAP estimates see a continuing deficit problem with outlays becoming an increasing burden. The problem is obvious - the US is not using its cash receipts in a responsible manner. Giving out more than we have, while creating more of what we don't have is just nonsensical, and it must stop.

If we are forced to default, Treasury will use less scare rhetoric and will explain what we are defaulting on exactly. T-Bills come in periods, so we still have some room to get our act together, broken up by each issuance and disbursement of debt. But a grand overhaul to orchestrate each minuscule (billions are actually big) payment is essential. The US will be forced to create a strategic game play in which the Treasury is held responsible for a balanced budget of inflows to outflows, which means that the government must act with what's given. If the requester of Treasury funds needs more, then they should create more through revenue generation. That will help the budget of each municipality, state, and in a broader sense, the federal government. Creating $3 with $1 requires innovation, and better use of the private sector. Allowing people to do what they do best (create value), will increase cash receipts. It's up to the local politicians to get this right.

The government must be forced to balance its budget. Austerity is painful, but it's clear that the economy needs a step back to leap forward; the US recession needed that J-Curve. If the debt limit does not provide this force, the economy will naturally seek responsible action. And this is exactly what bond investors are thinking. Let's tap into the thought process of the investor.

Are the bond markets really worried about default? So far, there is no demand for higher interest rates to compensate for default. Yields are lower, while treasury prices rise, signaling increased demand for T-bills as a safe haven. Investors are not fleeing the bond markets, because the general picture is still sluggish growth (again, the economy will naturally push for responsible leadership). The safe haven is still viewed as a risk-free asset.

However, the number of Credit Default Swap (CDS) contracts are up from 600-1,000 so far this year. The one year to 15 year spread has tightened, as it is now more expensive to insure a one year bond compared to a fifteen year bond against US government default. Even though investors are buying more Treasuries, they are insuring against default by relying on CDS. Playing it safe. China is also diversifying its reserves outside of US Treasuries.

The Economist interviewed a bond strategist about the patterns she sees in the markets:

Priya Misra, head of US rates strategy at Bank of America Merrill Lynch, says anyone who thinks America might default for several weeks this summer should sell a bond with interest due on August 15th and buy one with interest due on November 15th, which would result in the price of the first bond falling relative to the second. But, she says, neither market pricing nor the chatter of clients shows such a trend.

The debate should focus more on a budget overhaul, and the debt ceiling issue will follow these standards.