Investors: Why A U.S. Default Will Be A Good Thing (SLV, GLD, TBT, TLT, SPY)
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August 11, 2011 12:14pm
By Martin Hutchinson: Now that Standard & Poor’s has finally slashed its U.S. credit rating, it’s more apparent than ever that a U.S. default is imminent.
So if you’re at all panicked by S&P’s decision to downgrade the country’s top-tier credit rating – and the resultant freefall in U.S. stock prices – brace yourself: It’s going to get a lot worse before it gets better. But make no mistake, it will get better.
In fact, at this point, a U.S. default is the only conceivable remedy to our debt affliction.
Here’s why …
The Wrong Road
The United States has been able to coast on its top -tier credit rating for far too long. The truth is, this country stopped being a AAA credit risk in early 2007.
That’s when the Bush administration’s excess spending and military forays into the Middle East sent us down the wrong road and ultimately drove the fiscal 2008 federal deficit to more than $400 billion. That’s despite the fact that the economy was at the top of an economic boom at the time.
It’s true that our fiscal position has grown substantially worse since then, but that’s mainly because of the G reat R ecession of 2008-09.
Even if an imaginary amalgam of Calvin Coolidge and Bill Clinton had been in the White House since 2008, inheriting the overspending already built into the system, the federal deficit still would have reached $700 billion to $800 billion over the last few years.
Just the bailouts of Fannie Mae, Freddie Mac, General Motors Co. (NYSE:GM) and Chrysler would have added enough to the structural costs of recession to push the arithmetic off kilter.
The Bush administration’s additional spending in 2008, U.S. President Barack Obama’s $800 billion-plus of “stimulus,” and the g rotesque addiction that Congress continues to have to subsidies for farmers, ethanol, and idiotic “green” energy projects have all made the position worse. But they only account for about half of the annual deficit.
Of course, while recent political decisions don’t bear much responsibility for the current lousy U.S. position, our current crop of politicians have been – and will continue to be – ineffective in their attempts to emerge from it.
The Slippery Slope
Far from representing $1 trillion or even $2.5 trillion in spending cuts, the recent debt-ceiling agreement will actually produce less than $100 billion in cuts, all in the fiscal years ending September 2012 and September 2013. Cuts beyond those dates will require further titanic efforts by future politicians.
Additionally, no major cabinet department has been abolished – or even downgraded. No major military operation has been terminated. And no major entitlement program has been cut. On the other side, even the low-hanging fruit of ethanol subsidies has not been eliminated from the tax code, and it seems very unlikely that taxes can be raised high enough to affect the problem without putting the U.S. into an even deeper economic hole.
Meanwhile, the recession that has already lasted nearly four years is showing no sign of giving way to healthy growth. Massive budget deficits and massive growth of debt are inevitable under these circumstances.
Therefore, the U.S. credit rating is on a slippery slope, and more downgrades are inescapable.
Standard and Poor’s already has said there is a one-in-three chance of a further downgrade. And i t seems unlikely that Moody’s Corp. (NYSE:MCO) and Fitch Ratings Inc. will maintain their top-tier ratings on U.S. credit since their competitor has already downgraded it.
From here on out, each incoming downgrade will be met by dire predictions of gloom, a slump in the stock market (NYSE:SPY), a boom in gold (NYSE:GLD) prices – and, extraordinarily, by a further decline in U.S. Treasury bond yields.
Future Credit Downgrades and a U.S. Default
The idea of a decline in the safety of U.S. Treasuries causing a flight to safety in which investors buy still more U.S. bonds is a sign that markets are truly irrational.
But if nothing effective is done, this game eventually will come to an end. As the U.S. credit rating is downgraded again and again, somewhere this side of BBB-minus (the lowest “investment grade” rating) the markets will finally panic and decide that U.S. deficits can no longer be supported. That will make it impossible to sell enough Treasuries to finance America’s debt burden.
As in the case of Greece last year, this is likely to happen quite suddenly. And when it happens, the market’s negative verdict will be irreversible.
Furthermore, since there is no kind Sugar Daddy such as the European Central Bank (ECB) standing by with its force of German taxpayers ready to bail out the U.S. Treasury, the U.S. will be forced to default.
That will be very painful in the short run, but in the long run will be a good thing.
After all, there is no reason why governments should be considered better credit risks than top- quality companies.
The Proctor & Gamble Co. (NYSE:PG) and The Coca-Cola Co. (NYSE:KO) make tangible products that people want to buy – and they do so at tightly controlled costs. So it’s clear that companies like these can repay modest levels of debt under almost any circumstances.
The same is not true for a government – especially one that makes no money itself, produces few goods and services of value, and obtains money only by squeezing its unfortunate taxpayers. Just imagine a world in which investors won’t lend to governments: That’s a world in which governments cannot overspend – they won’t have the money.
That’s a world in which resources cannot be diverted from the productive to the unproductive. That’s also a world in which economic power is determined by success – and one in which the chairman of Coca-Cola has more credibility than the U.S. Treasury s ecretary. Our leaders down in Washington may think that such a world is pure hell – a civil servant’s version of Dante’s Inferno.
But for investors like you and me, a world like that – where everything makes sense – is a financial Nirvana.
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Written By Martin O. Hutchinson From Money Morning
Martin is a Contributing Editor to both the Money Map Report and Money Morning. An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. At Creditanstalt-Bankverein, Hutchinson was a Senior Vice President in charge of the institution’s derivative operations, one of the most challenging units to run. He also served as a director of Gestion Integral de Negocios, a Spanish private-equity firm, and as an advisor to the Korean conglomerate, Sunkyong Corp. In February 2000, as part of the Financial Services Volunteer Corps, Hutchinson became an advisor to the Republic of Macedonia, working directly with Minister of Finance Nikola Gruevski (now that country’s Prime Minister). The nation had been staggered by the breakup of Yugoslavia – in which 800,000 Macedonians lost their life savings – and then the Kosovo War. Under Hutchinson’s guidance, the country issued 12-year bonds, and created a market for the bonds to trade. The bottom line: Macedonians were able to sell their bonds for cash, and many recouped more than three-quarters of what they’d lost – to the tune of about $1 billion. Hutchinson earned his undergraduate degree in mathematics from Cambridge University, and an MBA from Harvard University. He lives near Washington, D.C.