The Painful Consequences of a Debt Ceiling Increase

By Larry D. Spears

Failure to reach a compromise on a U.S. debt ceiling increase could result in an unmitigated economic disaster - one so unprecedented government and private analysts can't even accurately pinpoint all the potential consequences.

To avert this crisis, U.S. President Barack Obama wants a debt ceiling increase of $2 trillion, which analysts say would carry the country through the end of 2012. The president has moved the deadline for reaching an agreement up to July 22.

President Obama said the time cushion was needed to prevent a last-minute panic by the financial and debt markets that could "potentially create another recession" - panicking investors and possibly causing an economic meltdown even worse than the one in 2008.

But even after a debt ceiling increase is approved - though it would obviously produce a brief sigh of collective fiscal relief - the U.S. economy and markets will suffer painful effects, and almost no longer-term positive impact.

So what can investors expect once the U.S. debt limit is, in fact, raised?

Higher Rates and Inflation

The prospect that the country will be able to add $2 trillion to its tab over the next 18 months is unlikely to make potential lenders (i.e., buyers of Treasury securities) jump with joy.

Just ask your credit card companies for a 13.98% increase in your borrowing limits - assuring them you'll use every bit of it - and see what it does to your credit score.

This means a debt ceiling increase is likely to lead to a downgrade of the U.S. credit rating, which will cause investors to demand higher rates to compensate for the increased risk.

To gauge just how much higher, JPMorgan Chase & Co. (NYSE: JPM) recently surveyed its clients to see what they thought. According to The Washington Post, respondents from within the United States told the bank they expected rates to rise by 0.37%, but foreign investors - who hold about half of outstanding U.S. debt - predicted a rise of half a percent or more.

A rate increase of that size would boost U.S. interest payments on new debt by more than $7.5 billion a year. The cost of rolling over existing debt at those rates could rise by as much as $71 billion a year.

And there's no guarantee the increase would be short-lived. When a combination of similar events forced a two-week delay in U.S. debt payments in 1979, a study conducted 10 years later found it had caused interest rates to rise by an average of six-tenths of a percent for more than five years.

More borrowing and higher interest rates also will mean more inflation.

After all, even if the Republicans in Congress back down and allow some federal tax increases, there's no way those being discussed will be enough to cover the increased debt burden - or even the increased interest payments, for that matter.

The only way the U.S. can pay the increased interest - forget about principal - is to print more money. That means a weaker, devalued dollar, and higher prices for everything priced in dollars.

Beware the Market's Reaction

If (or when) the debt ceiling is increased, both stock and bond markets are likely to celebrate for a minute. Then they'll re-examine the longer-term effects and turn sharply lower, perhaps extending the slide for quite a while.

That possibility was demonstrated quite clearly back in the spring when, following S&P's April 18 decision to downgrade the outlook for U.S. debt to "negative" from "stable," the stock market's extended rally quickly stalled out and the major averages began a six-week slide. That drop carried the Dow Jones Industrial Average from 12,807 on May 2 to 11,897 on June 15.

Now the stock market is notoriously fickle, which it proved when the Dow then rallied back to 12,719 on July 7 -- in spite of the looming debt deadline.

But then it dropped 202 points last Monday and Tuesday, choosing to ignore President Obama's debt assurances and instead focusing on the growing European sovereign-debt crisis and S&P's threat to lower its ratings on U.S. Treasury securities.

If you have large stock positions that could be at risk in the event of a market collapse, you might protect yourself by purchasing put options on either your individual companies or on stock index exchange-traded funds (ETFs).

Starting a Never-Ending Cycle

The acrimonious debate we're seeing over a debt ceiling increase likely will exacerbate the political divide in Washington, making the federal government gridlock even worse than it has been. In fact, it's almost reached the point where the fight is more important than the issue itself.

Such a series of political standoffs, legislative logjams and other major inactions brings the final major consequence arising from this conflict: the prospect that we'll see a debt ceiling increase again ... and again ... and again.

The current request is for a $2 trillion increase - only enough to allow the government to keep borrowing until the end of 2012. Under the president's proposed budget for fiscal 2012, the level of publicly held debt will rise from $10.4 trillion at the end of 2011 to $13.2 trillion at the end of 2012 - and borrowing for 2013 would require lifting the ceiling yet again.

What's more, the upward debt spiral will increase - no matter what we do. With spending at current levels, the public debt will grow from today's $10.4 trillion - roughly 69% of gross domestic product (GDP) - to $20.8 trillion, or 87% of GDP, by 2021. The interest payments alone will grow fourfold to $800 billion a year, or 3.9% of GDP.

The impact of the debt service on the economy also will inflict damage, reducing the amount of money available for new investment and growth, and resulting in an annual drop in GDP of 0.7%, or 3.8% of the total, by 2021.

Of course, all these possibilities pale beside the outlook should Congress and President Obama fail to reach an agreement to increase the debt ceiling. The impact of even a one-month suspension of Social Security and Medicare payments - one proposed "temporary fix" - would surely cripple the economy and collapse the markets. And anything worse could be the gateway to a new recession - or even depression.

Be prepared for the debt ceiling increase by examining your areas of highest financial vulnerability and engaging in defensive investing: Take some steps to hedge your risks using such investment tools as options, inverse ETFs or precious metals.

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