The Road to Default: Deep DooDoo

July 16, 2011

(This article was first published on The Dancing Economist, and kindly contributed to R-bloggers)

Okay so what is the situation at hand? Well the inevitable default of the United States of course.  The U.S. will default regardless of whether Congress raises the debt ceiling. You may be thinking the following: But how can he say such a thing? Is there anything we can do to stop it? There is no way that can be true!

Let me convince you that we’re in deep shit.

First: Look at Italy. Until this past week they were considered a safe haven for bondholders. Then their eurobonds jumped up to 6% because investors got spooked. Nothing happened that would suggest that they are in fiscal demise. There is no real political instability or real danger of default and Italy’s banks are relatively well capitalized with mostly retail deposits.
The U.S. on the other hand has had petitions being signed by influential economists and businessmen urging congress to raise the debt ceiling to come to an agreement.  We also have had default and debt recently come to the center stage and center of attention. In financial markets, anything that even gets a little press ends up being way worse than initially anticipated. For examples of this just look at the subprime mortgage market and how early warning signs were easily dismissed.

In Charles Poor Kindleberger’s famous book on the history of financial crisis, one of the most tell tale signs of a major breakdown looming is when a central banker or someone important gives an early warning. The example we can draw from is in 1996 when then chairman Alan Greenspan warned of “irrational exuberance” to describe the tech bubble.  In terms of prescience we have seen numerous warnings from Benny Bernanke about our debt buildup.

No matter what happens the U.S. will default. Cautious investors should get the picture if they haven’t already that now is the time to cash out and see what happens.  I could be wrong- but the turbulence that will ensue regardless as Congress fights over what to do will not be worth the hassle.  My game plan would be to buy back in when yields spike and they could spike by quite a lot. S&P was even recently taking about downgrading U.S. treasuries to AA status regardless of a debt ceiling negotiation.  Yields will spike. I promise you and now you have to promise me to keep dancin’

Steven J.

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