US Default Unlikely

The US currently has a debt ceiling of US$14.3 trillion and Treasury forecasts estimate that if Congress does not raise the debt ceiling by 2^nd August then the US may default on some of its financial obligations.

This predicament has sent Congress into frenzy – and whilst the solution seems pretty simple (i.e. raise the debt ceiling as has been done previously), it has unfortunately resulted in a political tug of war between the Republicans and Democrats.

Many Republicans, especially those under the influence of the ‘Tea Party’ group, want the government to achieve budget balance by slashing spending without increasing taxes. On the other hand, President Obama and his Democrat colleagues are willing to cut spending – but want to raise taxes on the rich, so both can contribute to the deficit reduction.

It seems that both sides of government have become so obsessed with gaining the upper hand leading up to an election in 2012, that they have lost sight of more pressing economic issues.

In spite of the above, every political party agrees that a US default is unthinkable and neither wants to take the blame for the financial chaos that would ensue from a default. As a result the most likely outcome is at least a short term extension to the debt-ceiling.

The likelihood of US default was downplayed by the head of ratings agency Standard & Poor’s on Wednesday 27 July when he said that the credit rating company’s analysts don’t believe the U.S. will default. However they are awaiting agreement on a “credible” plan – to increase the debt ceiling and also reduce the long-term budget deficit. S&P President Deven Sharma also said that the biggest risk is a downgrade in the nation’s AAA credit rating because Congress cannot agree on a package of spending cuts and possible revenue increases.

Some of the proposed cost-cutting plans proposed by the Democrats and Republicans could result in the U.S. keeping its AAA rating, but S&P is awaiting news on the outcomes agreed to by the White House and Congress before making that judgment.

With all of this playing out like a Hollywood movie I cannot help but agree with Clifford Bennett, writer of the White Crane Report, who has long argued that the closer to the deadline that an agreement is reached, the more political upside spin can be created i.e. “Never fear, we have saved the nation from economic Armageddon”.

In the meantime markets are likely to remain volatile, as investors – fearing the worst – head for the safe haven of cash. Best not to follow the herd.