Five Shocking Debt-Limit Scenarios

If you’re worried about government shutdowns created by warring politicians in Washington … wait till you see the consequences of a true shutdown forced upon us by bond investors all over the world.

Despite the intense pain and embarrassment, born-in-Washington, garden-variety government shutdowns are temporary. They disappear just as soon as enough people on either side of the aisle come to their senses.

By contrast, even with herculean efforts and massive policy shifts to appease foreign investors, true shutdowns are more difficult to end and far harder to recover from.

In a moment, I’ll tell you about one such shutdown that took place 33 years ago.

But first, let’s focus on a more immediate concern — the debt limit and the threat of a U.S. government debt default just a couple of weeks from now.

According to the U.S. Treasury Department, Congress has only until October 17 to raise the limit. If it doesn’t, the Treasury says it will be down to just a small wad of cash that would be gone in a matter of days. The entire nation would be close to falling off the dangerous cliff of default.

Here are some possible scenarios:

Scenario #1
At the 11th hour, the warring factions reach a compromise and Congress raises the debt limit to fund the government’s operations normally.

Based strictly on history, this is the most likely result. It’s what has happened every single time in the past.

The outcome: Business as usual. No end to the rampant borrow-and-spend addiction of Congress; no end to the print-and-pump madness at the Fed … until, that is, bond investors rebel and force a different kind of shutdown (scenario #5).

Scenario #2
The U.S. government defaults on its maturing debts. 

Until today, I have taken the position that this scenario is too remote to deserve more than one line of ink.

But a closer analysis of today’s political posturing uncovers a growing group of Congressmen who would rather fight than switch … plus some who would even prefer a government default than compromise their values.

Their line in the sand: Unless Obamacare is postponed or modified in some way, let the default happen! In fact, they say, in the long run, the horrible consequences of default might even be a healthy wake-up call for the country.

The fact that these leaders haven’t flinched an inch — even in the face of a massive government shutdown — leads some observers to believe that they may pursue the same tactic even in the face of a government default.

If they do, and if the president abides by the law, we face the ultimate financial Armageddon for any government — not only the collapse of U.S. government bonds, but also the end to our global financial system as we know it today.

Regardless of the political radicalization of Congress, I continue to believe this scenario is the least likely.

Scenario #3
Congress lets the U.S. government default. But the president overrides Congress, invokes the 14th amendment and forces the government to borrow and spend exclusively by executive order.

This is a radical tactic that former president Bill Clinton endorsed two years ago during the last debt limit battle.

It’s also one that’s now advocated by some Democrats — including prominent leaders like Senate Finance Committee chairman Max Baucus, and House minority leader Nancy Pelosi.

In a New York Times feature article earlier this year, “The Politics of the 14th Amendment and the Debt Limit,” former congressman Jack Kemp and Ron Paul staffer Bruce Bartlett explained it this way:

“In 2011, a number of respected legal scholars asserted that a little-known provision of the 14th Amendment to the Constitution essentially invalidated the debt limit.

“That provision states: ‘The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.’

“Other scholars contended that this constitutional provision was archaic, that it related to factors specific to the post-Civil War period and had no present-day relevance. On the contrary, I believe a careful review of the circumstances surrounding enactment of the 14th Amendment shows a great deal of similarity to those today. …

“The purpose of the debt provision of the 14th Amendment was to say that national debt was beyond the realm of politics.

“In the words of Jack Balkin, a Yale law professor: ‘It was stated in broad terms in order to prevent future majorities in Congress from repudiating the federal debt to gain political advantage, to seek political revenge or to try to disavow previous financial obligations because of changed policy priorities.’ ”

Likely outcome from this scenario:

The President avoids an immediate default. But Congress initiates an impeachment process that paralyzes the balance of his term and plunges the nation into much of the same kind of financial turmoil that he sought to avoid.

Scenario #4
The president decides to pay off maturing debts but sacrifices nearly everything else.

In other words, the U.S. government, despite its long love-and-hate affair with debt, suddenly reverts to operating strictly on a cash-and-carry basis.

Bond investors and other debt holders get their money on time. But virtually everything else gets axed.

Instead of a temporary government shutdown, a big chunk of the government downshifts into a longer lasting — and far more devastating — semi-permanent shutdown.

The U.S. government, the world’s largest employer, goes far beyond the temporary furloughs of federal employees announced this week: It takes the next logical step and lays off hundreds of thousands of federal employees. Industries that service the federal government do the same.

The U.S. economy, already weakened by the self-imposed government shutdown that began this week, plunges into a virtually instant depression.

Scenario #5
Global bond investors rise in rebellion, dump their U.S. bond holdings and force a government contraction similar to that of scenario #4.

What’s unique about this scenario is that it has happened before — in 1980, under the Carter administration.

The federal budget deficit was huge, although not nearly as large as today’s.

Consumer inflation was taking off due to years of aggressive easy money by the Fed, although not nearly as aggressive as the Fed’s massive money printing and bond buying of the past five years.

There was fear of a hotter cold war, although not nearly as intense as today’s fears.

In response, bond buyers went on strike. It was virtually impossible for the United States government to sell its bonds at virtually any price.

Big U.S. government security dealers on Wall Street — such as Salomon Brothers and Merrill Lynch — found that they could not even sell small lots of bonds in the market. There were simply no buyers.

Other dealers, afraid of losses that would wipe out their capital, closed shop.

U.S. bond prices plunged uncontrollably — as much as five full points in one day. Interest rates skyrocketed — to nearly 17 percent for U.S. Treasury bills. The bond market virtually shut down, threatening to shut down the entire government — even the entire nation.

Can this happen again? Absolutely. In fact, among all the scenarios now before us, this is ultimately the most likely.

Indeed, most other scenarios may turn out to be little more than sneak previews that lead to this final outcome.

Good luck and God bless!

Martin