The great debt ceiling debate goes on in Washington. In one corner you have Obama and the Democrats proposing tax increases and budget cuts. On the other side you have the Republicans arguing that tax increases are a non-starter. Nowhere in the discussion is entitlement reform seriously mentioned. Without entitlement reform, debt ceiling discussions will arise once again. Ask yourself this question. Why did it take until 2011 to have any sort of discussion on the nation’s debt problem? We could conclude that people like Congressman Ron Paul and Tea Party activists have inserted debt and budget dialogue into the national consciousness. How much discussion would even be centered on the debt ceiling without Tea Party candidates garnering support in the 2010 elections? In Escaping Oz, I suggested that the future of the Tea Party, per se, was not guaranteed but that their appearance on the national stage meant that the likelihood of a viable 3rd party in future elections increased. Ultimately it is a 3rd party or a collection of 3rd parties that will present the greatest influence in creating a meaningful, sustainable budget. It is difficult to see the major parties (GOP & Democratic) taking a hard stand since that will mean facing the headwinds of entitlement reform.
The discussion on the debt ceiling has created this notion of an automatic default on the part of the United States. The debt ceiling means that the outstanding, funded debt of the country cannot exceed $14.3 trillion. We use the word “funded” to distinguish from the unfunded portion of the entitlement programs. This unfunded debt is a promise to provide a future benefit. The funded debt is a promise to pay back some amount of principal plus interest loaned to the government. When the government runs a deficit, it adds to the outstanding, funded debt. If the debt ceiling were not raised, it does not necessarily mean the U.S. has to default on their debt. What it does mean is that the U.S. Government cannot issue any new debt above the ceiling. It would mean that the government has to live within its means. It would mean that the budget would have to be balanced since any government expenditures would be paid from existing revenue sources. It would be like your credit card company telling you that your credit limit was frozen. There is no reason the U.S. would be obligated to default if the debt ceiling held firm. Short of Congress prohibiting the U.S. Treasury from paying principal and interest on the debt, there is no reason for the Treasury to withhold this payment.
How are investors reacting to the debate? I have written numerous times about the coming wave of conservatism that will swoop over the investment markets. The social cycle model I discuss refers to a change in the psyche of the individual investor who will be battered by stock and bond markets. Leigh Hamer, a senior public relations specialist at Scottrade, the online brokerage firm, related the following to me,
“I spoke with some branch managers across the country to get a temperature reading on the local atmosphere (Scottrade operates 505 branch offices nationwide in 48 states and D.C.). The concensus is that investors – the buy and hold individual – are waiting out the debate by holding cash until a decision is made.”
What is also interesting is how traders are responding to the debate. Leigh informed me that Daily Average Revenue Trades (DART) increased for most of July before falling sharply on July 28th. The month of July has seen optimism on Mondays (higher DART figures) and pessimism on Fridays (lower DART figures).
I do not believe the buy and hold individual will return with great gusto to the stock market. The psychological effects of the 2008 credit crisis and now the debt ceiling debate will slowly usher in a more conservative posture for this lot. If traders reach the same conclusion as the buy and hold crowd, the stock and bond markets should witness more volatility ahead.
Jim is the author of Escaping Oz: Protecting your wealth during the financial crisis and is the publisher of The Sentinel Financial Report.