If Government ‘Shuts Down’

On or around October 2, the US federal government will shut down – again. The actual date could be a bit earlier or later, depending on how the government’s cash flows.

Technically, the government should have shut down on March 15, 2017. That was the date that a congressionally approved temporary extension of the debt ceiling expired. So on that date, the amount of debt on the books ($19.808 trillion) became the new debt ceiling. Since then, the Treasury hasn’t been able to issue any more federal debt.

Instead of shutting down the government, the Treasury has been cooking the books to pay the bills. Payments to federal worker’s retirement and disability funds have ended. The Treasury has also borrowed against federal pension, Social Security, and Medicare trust funds. But that can only go on so long. Without congressional authorization to raise the debt ceiling, some government services will have to end in about a month.

President Trump and congressional leaders want to raise the debt ceiling without any more restrictions. It’s easy to see why. Politicians get re-elected when they spend money on things that benefit voters, and just as importantly, when they spend on things that benefit the people and corporations that finance their campaigns.

But the influential Freedom Caucus in the House of Representatives opposes an unlimited increase in the debt ceiling. It favors raising the debt ceiling “only” an additional $1.5 trillion – just enough to keep the government afloat until after the mid-term elections in November 2018. The Freedom Caucus also wants to cut federal spending. Trump and congressional leaders have to take the Freedom Caucus seriously because the Freedom Caucus’s opposition to the partial repeal of Obamacare doomed that initiative earlier this year.

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The History of the Debt Ceiling

While the debt ceiling has existed since 1917, when Congress was debating how to fund US military operations in World War I, it wasn’t a major political issue until the mid-1990s. In 1995, Democratic President Clinton vetoed the spending bill for the 1996 budget that the Republic-dominated Congress had prepared. That budget sharply cut funding for Medicare, public health, education, and the environment. The bill also prohibited the Treasury from borrowing from federal pension or other trust funds to make up the gap between federal income and expenses.

After repeated efforts to forge a compromise failed, on November 14, 1995, the federal government partially shut down. After five days, Congress passed a continuing resolution to fund the government for an additional month. When that funding expired, the government shut down for another 22 days.

Public opinion largely blamed the Republicans for the shutdown, but in 1997, a bipartisan consensus emerged in Congress to cut government spending. The result was four balanced budgets in a row, for the first time since the 1920s.

How the Next Government Shutdown Will Unfold

The best-case scenario for the looming shutdown would be a bipartisan deal along the same lines. In exchange for sharp cuts to entitlement spending, which Democrats want to avoid, Republicans would approve a higher debt ceiling.

That outcome is very unlikely. Congress is far more polarized than it was 20 years ago. And in a recent poll, 57% of Americans opposed raising the debt ceiling, versus 20% who favor doing so. A partial shutdown seems inevitable.

To prepare for it, it’s important to understand what parts of the government will be affected.

There are two major sources of government spending: discretionary and non-discretionary.

Discretionary spending represents expenditures that are authorized in annual congressional budgets. The Treasury will cut that spending first. That means hundreds of thousands of federal employees will be placed on furlough. Many government agencies will suspend operations. National parks will close. The FDA won’t process applications for new drug therapies. And the IRS won’t answer the phones (although even now, it’s hit or miss getting through to a live person).

Some discretionary funding (national defense, border security, etc.) will continue, although perhaps at a reduced capacity.

Non-discretionary spending represents mandatory expenditures that have been permanently authorized by Congress. These include interest payments on federal debt, social security, Medicare, etc. So the Treasury can’t stop making those payments. But new applications for social security or Medicare benefits might not be processed until the shutdown ends. And if you have questions about those benefits, good luck finding someone to respond to your emails or phone calls.

If the shutdown continues indefinitely, mandatory expenditures would be affected. For instance, in the 1995-96 shutdown, the Treasury announced it wouldn’t be able to make social security payments if the spending freeze continued.

That won’t happen this time. After a few weeks, Congress will cobble together a deal. Another political crisis will end, at least temporarily.

A Shutdown Doesn’t Change the Fact the US is Broke

Longer term, the situation is much more serious. If Uncle Sam were a corporation, it would have been declared insolvent decades ago.

The $19.8 trillion national debt is only one small part of a much darker fiscal picture. Indeed, the audited financial statements compiled by the General Accountability Office for 2015 concluded that the federal government has a net worth of negative $18.2 trillion. (Yes, with a “t.”)

And believe it or not, that’s the good news.

The bad news is that the “fiscal gap” – the deficiency in financing for unfunded mandates like social security, Medicare, and military and federal pensions – now exceeds $200 trillion. And that doesn’t factor in the cost of future wars with North Korea or any other nation or group Donald Trump or a future president decides to fight.

Now, without a debt ceiling, the Treasury can continue to issue debt – notes, bills, and bonds of various maturities. And if it can’t find anyone to buy them, the Federal Reserve can step in. That was a big part of the Fed’s quantitative easing initiative (QE) to spur the economy out of the last recession. Indeed, nearly half of the Fed’s balance sheet consists of federal debt.

Could that go on forever? Some economists predict that QE will eventually lead to hyperinflation. If they’re right, your social security check will cover only a week’s worth of groceries, not an entire month’s worth of expenses.

Inflation is good for the government in the short term, because it can repay its obligations in dollars that are less valuable dollars than the ones it borrowed. But over the longer term, inflation will leads to higher interest rates. Businesses would will have to pay more to borrow money. Consumers would will have to pay more to buy a home. Economic growth would will slow.

If this process continues indefinitely the US would eventually start to look a lot like Venezuela does now. The value of the dollar would drop like a stone, and your US dollar savings would become worthless.

But I’m not sure that inflation is the inevitable outcome of unlimited QE. For QE to spur economic growth, consumers and businesses must be willing to borrow, and banks must be willing to lend. And that hasn’t happened in Japan, which has embarked upon the world’s largest QE stimulus over the past 16 years to prop up its economy. The Bank of Japan accelerated QE in 2013, announcing its commitment to purchase ¥80 trillion ($733 billion) of bonds annually. Japan is an example of QE on steroids, but inflation is running at only 0.5% annually.

Because of the Japanese experience, I think a more likely outcome than inflation is more economic stagnation, no matter how much QE the Fed engages in. And keep in mind that while QE doesn’t stimulate the overall economy, it’s very effective at producing bubbles in the price of stocks and other assets. When the bubbles burst, we’ll experience a repeat of the global financial crisis of 2007-2008.

Except it will be worse this time. Many of the world’s largest banks will be bailed in, and depositors will get worthless stock back in exchange for their savings. And yes, there will be even more QE by the Fed to try to clean up the mess. Not to mention endless escalations of the debt ceiling by Congress.

How do you prepare? Personally, I’m holding assets that can survive both inflation and deflation:

1. Cash in banks with rock-solid balance sheets to take advantage of depressed prices if there’s another global economic crisis like 2007-2008; and
2. Gold and other real assets as inflation hedges.

Reprinted with permission from Nestmann.com.

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