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Economic News & Analysis—October 3, 2013

Treasury plays politics: Says default would be bad

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

The U.S. Treasury released a six-page statement saying that the U.S. government defaulting on its debt would be bad. This is probably a good reminder to politicians that this game of brinkmanship can be damaging to consumer and business confidence, but it’s not a particularly useful statement to investors.

The report starts by saying the U.S. has never defaulted on its obligations. That’s just not true! In 1979, the Treasury missed making payments on a small amount of debt (approximately $120 million). It was due to a technical glitch, but it was still a default.

The report also confuses correlation and causation. The stock market started to decline at the end of July in response to gross domestic product revisions that showed the U.S. economy was weaker than previously reported, and the falloff was exacerbated by the problems in Europe, especially in Greece. It didn’t help that on August 5, European officials basically told markets, “Just trust us” to deal with the crisis. Investors clearly did not trust them to. There is no doubt that the political brinkmanship in the U.S. didn’t help matters, but it was not the sole or even the primary cause of the market turmoil.

But wouldn’t a default be bad?

Yes, a default would be bad, but it doesn’t have to happen, even if the debt ceiling isn’t raised. The Treasury would need to operate on a cash-flow basis, meaning it would need to have money in the bank to pay bills as they come due. With the net flows into the Treasury—especially if the outflows are less due to the partial government shutdown—the Treasury can easily meet its interest obligations on the debt. When I look at the legislation that created the debt ceiling (the 1917 Second Liberty Bond Act), subsequent laws commanding the Treasury to pay interest on the debt (Section 3123 of Title 31 of the U.S. Code), the Constitution (section 4 of the 14th Amendment), and Supreme Court precedent (Perry v. United States), it seems clear to me that only if the Treasury secretary chooses to default on the debt would there be a default. Thus, unless either the president or the Treasury secretary chooses to default on the debt, there won’t be a default on the debt.

Timothy Geithner tried to play this same card when he was Treasury secretary. In the run-up to the fiscal cliff, he said the market was going to tank unless Congress caved. He was wrong. The market saw that his words were hollow and recognized that he was playing a political game. Politicians want markets to tank or explode to the upside on their every word to make their opponents cower. That was true then, and it is true now. Investors should just take all this in stride or try to tune it out.

For more perspective on what investors should be watching (hint: not just Washington, D.C.), check out the Market Roundup, where my colleagues and I discuss the economy, equities, and fixed income and give our recommendations for asset allocation.

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