At its most fundamental level, the U.S. is divided by two competing visions of the size and role of government in society. The division runs along social, economic and, most important, geographic lines. Until the divisions are resolved, the sort of power struggle we are seeing now will return regularly. Company managements should plan on a high level of instability in regulatory and tax regimes. Investors, for their part, should plan on higher levels of market volatility resulting from regularly repeating spasms of intransigent conflict in D.C.
Obviously the budget is being used as a tool in a separate power struggle that's only abstractly related to the actual debt. All is fair in love and "war," and the very serious issues that underlie this struggle have a 0.000% chance of being resolved as this plays out. However, the odds are also 0.000% that the U.S. would miss an interest payment and/or default on principal payments for maturing notes. Anyone blowing out U.S. Treasuries on increased default risk is really making a political statement, not an economic one.
In an effort to reduce all of our stress levels, I'll consider the ways the U.S. government can continue to meet its obligations even if Oct. 17 passes without a deal:
• Off-balance-sheet transactions. Just as Enron did, the government could temporarily sell assets to the Federal Reserve under repurchase agreements to return them later. For instance, the Fed could pay the Treasury $100 billion for the Washington Mall, or a naval base, or some similar asset, which then would be repurchased next month. Enron CFO Andrew Fastow is out of jail and back on the speaking circuit, and would be available to consult as needed.
• Creditors can factor receivables. In order to make interest payments, the government could defer payments to other trade creditors, such as defense contractors. Those creditors could simply wait, but the amounts involved present an enormous challenge for making payroll and paying suppliers. The creditors could factor the receivables to the Federal Reserve. The Fed can certainly buy that paper, as it seems to be relatively free to buy any financial asset, and of course obligations of the U.S. government are far less risky than the mortgage securities they are loaded with today.
• Forgiveness. The Federal Reserve and Social Security trust fund could simply forgive, waive or (for the trust fund) defer this month's payments. Those two entities own 29% of the federal debt, or $6.9 trillion, and they receive approximately $8 billion per month in interest, based on my back-of-the-envelope calculation. This wouldn't completely fill the gap, but it certainly wouldn't hurt.
• Scrip. In 2009, when California was on the verge of bankruptcy, it issued scrip in lieu of cash for obligations like vendor payments, tax refunds and so on. If one state can do this, certainly the federal government can as well!
• Make payments in gold. The Treasury owns $11 billion in gold. It can use that to make payments. Our monetary system no longer purports to have the backing of any precious metals, so why do we need to hold gold -- and incur the storage and management costs -- anyway? Let's use it to make payments this month. The government can send gold certificates immediately, and then arrange physical delivery later.
• Lottery. This would be tougher to do quickly, but the idea of funding government spending via lottery proceeds is established at the state level, so why not nationally? What would be sales for a $1 billion jackpot, for instance?
• Gift cards. Keynesians all agree that the economy needs more aggregate demand. So, rather than making payments in dollars, the government can distribute Wal-Mart (WMT) or Target (TGT) gift cards. Social Security, welfare and payroll recipients should not really care what they receive, as long as purchasing ability and power is retained, which it would be. This would serve the double purpose of stimulating consumer demand while eliminating the potential for default. The Federal Reserve would purchase the cards from the selected retailers on behalf of the Treasury, of course. Think that is ridiculous? The Japanese government actually considered a similar plan in the 1990s!
As you can see, the government has plenty of options. If you are observant, you've also noticed that most of these rely on the Federal Reserve's cooperation. This brings up the serious point that our own Mike Norman and others make often: There is no real reason for a government to default when it issues its own currency. We do not need a trillion-dollar coin in order for the Federal Reserve to create all the money necessary to meet our obligations without issuing additional Treasuries. I place my full faith and credit in the belief that there are plenty of loopholes that would allow the Fed to cover our obligations as needed until the crisis passes.
Of course, using pure money creation to fund government activity would cause the progressive devaluation of the currency -- which is the flip side of inflation. Inflating in this sense is the most time-tested strategy for funding government spending, but of course it is also the most regressive. The wealthy are more equipped both to anticipate inflation and to devise strategies to protect themselves from it, so an inflation system for funding government will place the burden squarely on the working classes and/or those that rely on labor rather than assets for income.
My own risk-reduction strategy has really remained unchanged over the last couple years. I have no interest in fixed income, since it represents a lot of risk for no return. Even if interest rates fall again, your capital gains on the bonds will be limited, and your income nonexistent. But if rates rise, get ready to be creamed in capital losses.
I want to own mostly equities that pay a nice dividend, with a smattering of gold -- 10% to 20%, maximum -- as a hedge. Gold would basically serve as an alternative currency for cash holdings. Equities in companies with pricing power will hold their value over time and in most economic conditions. For example, if you own Altria (MO), you can feel comfortable that people will be smoking 10 years from now. (If you worry about it in the U.S., then own the international side of it -- Philip Morris (PM).) Other inflation-protected asset classes, such as real estate, could be OK too. Just diversify your exposures away from any specific market concentrations.