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Money Morning: U.S. Debt Default Worse Than Lehman Brothers Collapse?

July 28, 2011 0 Comments

U.S. Debt Default Would Be Worse Than Lehman Brothers Collapse

Each day that passes without a deal to prevent a U.S. debt default brings the United States closer to a financial calamity that would be more severe than the failure of Lehman Brothers in 2008.

Dueling speeches from U.S. President Barack Obama and Speaker of the House John Boehner, R-OH, Monday night did nothing to resolve the impasse between Republicans and Democrats over how to reduce budget deficits and raise the debt ceiling past the $14.3 trillion limit by Aug. 2.

The contentious rhetoric of recent days has raised concerns that lawmakers will fail to reach a compromise by the deadline – with disastrous consequences.

"I've never, never seen a breakdown like this," Paul Light, a U.S. government scholar, told Reuters. "This is a defining moment in America's inability to act."

Should the deadlock over avoiding a U.S. debt default endure past Tuesday's deadline, it will trigger a financial crisis of vast proportions:

  • Plummeting equities: When Lehman Brothers failed, the Dow Jones Industrial Average dropped 504 points in one day, and kept falling for months afterward. A default by the United States on its debt could hit even harder. Lance Roberts, CEO of Streettalk advisers, told The Fiscal Times that stocks could fall 50%. That would torpedo retirement accounts and hurt investors large and small.
  • Missing payments: the government borrows about 40% of what it spends every day. If it can't borrow, then it will have to cut spending by 40% immediately – more than 10% of gross domestic product (GDP). That could mean missed payments to government contractors and recipients of government assistance. It may also mean that hundreds of thousands of federal workers will be furloughed without pay. In addition to the personal pain, billions of dollars in government spending will vanish from the economy.
  • Interest rates: Credit rating agency Standard & Poor's already has warned of a 50% likelihood that it will downgrade the credit rating of the United States in the coming months – as much for its high debt levels as the possibility of default. If lawmakers allow a U.S. debt default, S&P says it will cut the country's credit from AAA to D. That would mean higher interest rates (and higher costs) not only for U.S. debt, but for all credit. Because other types of lending – including home loans, credit card rates and student loans – are based on U.S. Treasurys, the cost of borrowing would skyrocket for consumers and businesses alike.
  • States and cities: Likewise, states and municipalities would face higher borrowing costs, since their rates, too, are tied to Treasurys. That will make all capital projects – roads, water systems, hospitals, schools – more expensive.
  • Credit crunch: Higher borrowing costs and financial turmoil could lead to another credit crunch like the one we saw following the Lehman Brothers collapse. And that would further strangle the U.S. economic recovery.
  • Bank crisis: A less obvious problem arising from a U.S. debt default would be how it affects large banks, which use Treasurys as collateral for their own borrowing. "What happens if treasuries as collateral aren't seen as the risk-free instruments they have been?" said Money Morning Contributing Editor Shah Gilani, who is worried about the impact of discounted Treasury holdings on the banks' leveraged positions. "Could an ugly round of global de-leveraging undermine investor confidence again and derail hoped-for economic growth?"
  • Lower dollar: Already in a years-long slump, the dollar will sink even further against the world's other currencies. S&P has estimated a U.S. debt default could cause the dollar to drop 10% or more. A weaker dollar will make imports more costly, but that's not the worst of it. A default or credit downgrade could cause the dollar to lose its status as the world's reserve currency. And that would be very bad for the U.S. economy.

Combine all of the above and you can see how a U.S. debt default could implode an already shaky economy. Not only would the recession return with a vengeance, but the economy could sink even lower than it did in 2008-2009.

"It's conceivable the worst-case scenario is that the entire financial system of the world just freezes up, and it will make what happened with Lehman Brothers look much less by comparison,"Bruce Bartlett,a former Reagan White House policy adviser, told The Fiscal Times.

7 Responses

  1. Paul G Huber | July 27, 2011

    Sir
    You like to writer stories about finances and stocks. Why not write one about what will happen when the greenback is so inflated it goes the way of Nazi Reichmark or the Zimbawee Dollar? What sort or anarchy would exist during a transition to reforming our government or our monetary system and how might they go about it? Could the US Military take over as happens in other countries? What might life be like? And perhaps a detailed list of what to own and what not to own before during and after? Something more detailed then the obvious Guns & Gold, Bullets, dried food, silver? What skill sets would be in demand?

    And if I own 100 shares of XYZ company after a transitional period, would I not still own some portion of XYZ Company?

    Lastly, I hate these little boxes to type your message. Why not make it so my Outlook pops open and I can spell & grammer check. My apologies for and typos or disjointed grammer.

    Paul G Huiber, CPA

  2. Paul A. Teel Sr. | July 27, 2011

    The best Case scenario: Give Obama a two month extention; enough time for the gov't officials to identify the absolute total amount of the US spending at that instant. Also provide a complete list of each incividual component of the spending, including the recipient of the money and the purpose of each component. Independently verify (a panel of young experts with no axe to grind) that the list equals the total provided above. Allow the same panel of young experts (age group 35 to 50) to slash sufficient lines of the list to balance the budget. Fix the spending ceiling and establish the individual spending percentages to leave a 5% surplus after all debts are being paid, including the interest on the current debts. Until the debt is eliminated, no free spending by the president, congress, or any other govenment official or party. Certain current expenditures are to be treated as sacred. These include Social Security, certain government payrolls, etc. It is my opinion that drastic action of the type is absolutely necessary. The poor will hurt as usual, the rich will attempt to become richer (on a relative basis) and the country will suffer a severe shock. However, the shock will abate, but the rich need to become poorer and the poor wealthier. No French Revolution, if possible, but a massive and gross adjustment is necessary to reconstruct the path this country should be taking. The current crisis is cannot be corrected without a severe restructuring. I am no expert, but this is the situation I perceive.

  3. Russell Sanderson | July 27, 2011

    I'm for maintaining the current debt ceiling and let the chips fall where they may. Does anyone feel that by increasing the ceiling now would avert it needing to be raised again when the true costs of Obamacare are know. Oh, by the way, there is little discussion about our $100 billion unfunded liability to Social Security and Medicare. How about the fact that there is no retirement fund sitting there for military retirees; it's paid out of the annual defense budget. The same is true for disabled veterans who have sacrificed for our country that is now considering that we may not pay the war wounded.

    Some ideas:

    1) Immediately stop all foreign aid except for Isreal (Did you know that we give foreign aid to China and Saudi Arabia (look it up)

    2) Immediately pull all troops out of Afghanistan and Iraq; most of the bad guys have moved to Somalia. Iraq and Afghanistan are not worth one drop of american blood.

    3) Bring home all of our troops from Europe; let them remain in S. Korea because of the madman to the North.

    4) Drill Baby Drill ! You idiots!!!!!! Get nuclear powerplants up and running. Forget Chernobyl, that was a man-made disaster caused by two scientists. Start tapping our natural gas deposits. Pursue clean coal. Eliminate all environmentalists and their snails and frogs.

    5) Consider closing several embassies; people hate us anyway

    6) Draw down the size of the military force (remenmber we're out of all wars) and let Reservists go home to their families.

    7) Take back the 16% raises that Obama just gave to all his staff.

    8) Smash the printing presses at the treasury

    9) Sorry, but I've run out of time.

  4. j gordon | July 27, 2011

    I believe the US gov. would like to have a clever , silent , selective default in order to shed some debt.

  5. Bea Herrick | July 27, 2011

    This is exactly what Oboma had planned all along. He does not like this country, does not believe in democracy and wants to destroy our way of life. This is his opportinity to do so and blame everyone else. I hope someone has the know how to avoid all of this be it either party. He as never had a job and really does not understand what he is doing. He needs to step down. He said after the election WE WON SO SHUT UP Bet he wishes he had not won. Life as we know it is gone.

  6. Mike Dunn | July 27, 2011

    First of all there is no reason for a U.S. Default. There is plenty of revenue coming in to service debt payments. Who came up with this artificial Aug 2nd default date? Just pay the interest payments on the debt as they come in. David Zeiler and other media types are trying to panic the financial markets & the American people into believing financial Armageddon is about to occur. The main goal is to get Boener & the house Republicans to cave in on real spending cuts as they always do under media led pressure. Doesn't anyone realize we are broke as a nation and can not continue to run up huge massive spending deficits, year in and year out. The problem is do to baseline budgeting that mandates increased spending each year. We have a spending problem not a revenue problem-Mike

  7. Meg in Minneapolis | July 28, 2011

    When Republicans morphed into rogue elephants, they abandoned democratic principles. Instead, they use tactics to have everything go their way, or no way at all… for only they are "right."

    I'm sure that each of us has had conversations with the sort of people who are "right." They disregard our viewpoint, disregard statistics, disregard needs, and disregard history. The best response to such people is to CLOSE THE DOOR to further communication on the topic. By refusing to engage with bullying tactics, we at least gain some respect. And in the future, the always-right sorts may change their approach and deal with us more as co-equals.

    Rogue elephants are crazed. Rogue elephants trample all in the path. Rogue elephants are irrational. When trying to deal with the Republican rogue-elephants, it does no good to appeal to tenets of democracy. For they will not adhere to principles of compromise, majority rule, and justice.

    So I think that the only effective tactic is to disengage and evade so that the nation does not go into default. Otherwise the rogue elephants will push us all over the cliff.

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