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What Shutdown?

09/29/2013

Imagine sitting in a high-powered car in the parking lot of a school when classes are dismissed for the day and putting the car into Drive just before jumping out.  Imagine giving Roman Candle fireworks to teenagers living in a shantytown.  Imagine being in a large crowd and firing hundreds of rounds from an AK-47 straight up.  In each case, it is unlikely to have a good ending.

That’s how I think about a debt default, if Congress does not raise the debt ceiling within the next thirty days.  All sorts of bizarre scenarios are possible, and none of them are good, at least in the short run.

Certainly, the stock market will drop, as uncertainty increases.  Certainly, the cost of credit default swaps on ALL U.S. bonds will increase, driving down the market price of those bonds, which increases interest costs to taxpayers.  Certainly, the dollar will fall, as investors attempt to decrease their exposure to a dysfunctional government.  Certainly, the price of oil will drop as future demand can be expected to drop.  Certainly, gold will increase, because it is the last bastion.

While we do know this much with great confidence, we don’t know how severe the reaction will be, nor how long it will last.  Many nations have defaulted on their debt before, but no nation with a reserve currency has ever defaulted.  The dollar has been the world’s only reserve currency since the end of World War II.  (In fact, the U.S. used its dominant position as victor, some say unfairly, to require Europe’s international contracts be expressed in dollars, insuring supremacy or reserve status of our currency.)

Besides credit default swaps, other types of derivatives scare me the most, since they are not traded on any transparent exchange.  This is part of the Dodd-Frank bank reform that is still not implemented, due to stonewalling by the industry.  Nobody, and I mean nobody, knows what is out there in derivative form.

Once we default, we will set into motion a great many things we cannot control.  With great respect for the highly innovative Ben Bernanke, not even the mighty Fed will be able to insulate us.  That is why I expect the stock market to trend down for the next two weeks, at least.  If you are an income investor, you can probably expect a big paper loss but no change in income.  If you are a growth investor, you can expect some great buying opportunities ahead.  But, be prepared for sudden, violent changes.  Only high frequency traders, who trade in milliseconds, will benefit from all this.  Long-term investors will eventually be fine, except long-term may become longer-term.

Congress has been frequently accused of protecting Wall Street instead of Main Street.  That is certainly not true now, as they are NOT protecting investors from a debt default!  Wall Street will be harmed quickly, but Main Street will have time to adjust.

And, no, I’m not interested in the government shutdown.  That is so unimportant, compared to a default on U.S. government debt.  Depending on your politics, you may be happy or sad that — the longer the shutdown, the stronger the President’s hand in demanding the debt ceiling increase.  I don’t care who “wins,” as long as there is no default.

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