Today, I participated in a conference call with the senior economists from TD Ameritrade. These notes are taken directly from this call. I must credit TD Ameritrade for a great job in detailing the four most likely outcomes and the ramifications for each scenario.
Scenario 1….”to dream the impossible dream”
In this scenario, congress finally agrees to the “grand bargain” whereby $3-4 trillion in financial austerity is agreed to. This is the most optimistic scenario and probably hard to achieve within the short time frame of only 4 days. But this agreement would yield the most positive financial market reaction. And a rough path would be carved out for a more sustainable US budget picture. But while the markets would calm down, this will come with a huge economic price as our GDP growth will slow down over the next several years. It will be a painful process as we move towards a balanced budget with expenditures not exceeding income and severely trimming the deficit. Something that absolutely needs to be done but folks, there will be pain in the process.
Scenario 2…”no harm..no foul”
In this scenario, a last minute deal is struck and government operations are not affected. However, this deal involves only an incremental increase in the debt ceiling in exchange for ongoing discussions of further reductions etc… Standard and Poor’s will most likely downgrade the current AAA status of the US government because they do not see a long term plan in place for reducing the deficit. Having said this, it will only have a benign impact on the US economy. Other rating agencies do not appear inclined to follow Standard and Poor’s. The markets should react favorably in the short run.
So, while we dodged the bullet in the short term, we still need to come up with a long term plan much like the “grand bargain” cited above. We have just kicked the can down the road.
Scenario 3…”a flesh wound”
In this scenario, no agreement is reached before the Aug 2nd deadline. S&P downgrade is certain and also the risk of downgrades by other rating agencies. We will have a double hit to the economy. Approx $135 billion a month would be withdrawn from the US economy (this is the current shortfall resulting from $165 billion a month in revenues and $300 billion a month in expenses). You can imagine the immediate impact of spending $135 billion a month less and how this will slow down the economy. The second hit would come from a rise in Treasury yields (our bonds would not be as credit worthy, so therefore we have to pay investors more to buy them). If the situation is only for a few days..a week at the most, the impact will not be disastrous. We clearly have the revenues ($165 billion a month) to pay our debt and the debt payments would receive first priority. So we would not default on our interest payments but other government expenditures would be severely cut back. Gee—maybe Congress would not get paid! But if allowed to continue for the entire month of August or later, then we could certainly be back in a recession. Bottom line is that this scenario would lead to short term financial turmoil that will weaken an already weak and fragile US economy. But not the end of the world.
Scenario 4…”a mortal blow”
In this scenario, there would be an actual default because Congress has been unable to reach any type of agreement and it has dragged on for too long after the 8/2/deadline. This would be considered a technical default as the Central banks understand this would be caused by bi-partisan politics and not the inability of the US to pay its debt. While we may receive grace from the financial markets, the rating agencies would lower our rating to “SD” which stands for selective default. This is unknown territory for the US. Interest rates on our government bonds would probably rise dramatically. Investors would flee from treasuries (once considered the safest investment in the world) and there would be a rash of redemptions. Stock market would tank and there would be a total freeze in the credit markets. We would be plunged back in to a deep recession.
So what do I think will happen? Much as I would love to see #1, I just do not think it likely due to the late hour but who knows…miracles do happen. I think there is a 75% chance that the#2 scenario will occur and 25% for # 3.
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