Current Debt Crisis – A high stakes game of “Chicken”?

19 07 2011

by Michael Carignan, CFP®, CRPC®

Do you remember watching the old classic movies where two guys get in a  fight over a girl and they head out to the quarry for a game of chicken?  If you do, you might see some similarities to what’s going on in Washington right now.  The difference this time, however,  are the consequences for all of us if neither one of them blinks.  The controversy in Washington is loud and filling the airwaves with political rhetoric and scare tactics.  And, if you listen to the media, there might be some potentially disastrous consequences if our elected officials don’t come to an agreement soon.  So we thought it would be helpful to analyze this issue, try to understand what is going on, then turn to the history books to see if something like this has happened before and how it turned out.

While the current situation certainly can be frustrating, it actually is the result of the checks and balances built into our constitution.  While the President can authorize actions and spending bills,  it is up to the Congress to actually finance them.  Right now there is a disagreement between house Republicans – who hold a majority, and the President on how much is reasonable to spend and on what.  Without going into the individual spending priorities for each of them and their merits, let’s just address the most basic elements.  The President would like to spend more and raise taxes to cover the current spending needs – while the house Republicans want to cut spending dramatically (~$2T over 10 years) with no tax increases.  Each side of the argument has valid points, but neither side seems willing to compromise enough to make a deal at this point.

In the press, we are hearing that if the debt ceiling increase is not approved then the US Government is going to default on its obligations.  What does that actually mean?  The most common things we’ve heard are that the government will stop paying soldiers, medicare benefits and/or social security benefits.  What does that make people feel?  “PANIC”!  Even worse, we hear there may be a full default on US treasury debt across the board.  More PANIC!  The news evokes a significant emotional response, with the intent of making the audience watch more of the TV news to see if anything has happened in the last 30 minutes to change the situation!   Can either of these scenarios happen?  Yes, but let’s put it in simpler terms to try to understand the entire issue.

Let’s say a husband and wife are looking at bills coming due over the next few months and realize they are coming up short on money in the bank, because of a combination of things (say, medical costs, car repairs and overspending on luxury items). The wife refuses to let more money go onto the credit cards unless the husband agrees to reduce spending.  He still wants to keep going out to eat and tells her she needs to get a second job.  Neither of them want to relent and they keep getting closer and closer to the date they will have to pay the bills and still no agreement to increase the credit card limit.  What do they do? Do they refuse to pay ALL of their bills across the board and shut down the household? Do they declare bankruptcy?  Or is it more likely they will decide which bills have priority, and which ones, if not paid right away, are least likely to cause permanent damage and delay paying on those?

This appears to be the most likely scenario.  For those who are watching the news and listening to the pundits spin out their theories for what disaster is looming if politicians don’t come to an agreement, you may be asking if this has happened before.   You don’t have to look too far in the past to see another example.  Many in the press will say this is unprecedented, and the particular doomsday scenarios vary from channel to channel,  but the November 1995 government shutdown was quite similar in nature to the situation we face now.  Let’s see if this sounds at all familiar.

1. The Republicans in Congress are unhappy with the President’s desire to spend more money on entitlement programs than they like.

2. The President is unwilling to cut programs to the level that Republicans want and is unwilling to sign a budget and debt ceiling increase that are presented to him.

It seems that in both cases you can substitute Bill Clinton and Barack Obama and voila!  Today’s scenario recreated.  In 1995 the buzzwords were “balanced budget” and now the focus is on “debt reduction”.  The basis for the stalemate may be slightly different and some of the facts are different but it is actually a close parallel to what’s happening today.  So what happened when the government “defaulted” in 1995?  They suspended all “non-essential” government spending until there was an agreement.  Each side played the media to the max – pointing fingers across the aisle and blaming the opposition for the entire flap.   The Federal Government did not default on interest payments, nor did the Government stop paying soldiers, retirees, Social Security, or Medicare.  Instead, they did furlough government employees in the Environmental Protection Agency, Forestry Service and Department of Health.  They closed buildings and public parks but continued to fund the basic services we need to keep the country safe and functioning.

Was it a comfortable time?  Not at all.  Many  people were affected, and for a period of time the populace really wondered how much worse it might get.  Did the US markets crash? No…they were virtually unaffected.  In some opinions, the government shutdown actually had the benefit of bringing spending back under control and getting us to a point of an actual surplus — even if it was only for a brief period of time.

My intent is not to disregard the potential financial impact that a deadlock between Congress and the President could create, but instead to point out that putting the current situation in a historical context can help us have a better appreciation for what might happen, and how it may affect our lives individually.  None of us can have a direct impact on the negotiations in Washington, but there are things we can do to sleep better at night.  First, it is important to be financially prepared for unforeseen and uncontrollable events.  Even government employees can have a problem with a paycheck not showing up on time, so make sure you have adequate short term savings to cover a few months expenses.  Second, make sure your investment philosophy matches your risk tolerance.  If you find yourself overly concerned with the short term market impact of a negative news story, you need to consider whether or not your risk tolerance is appropriate.  “Flip-Flopping” back and forth between an ultra conservative risk tolerance, and a more aggressive one – essentially letting the media yank your strings – is a recipe not only for financial disaster, but will likely cause ulcers and high blood pressure as well.  Having a good understanding of what your particular investment philosophy is and how much of the market fluctuations you are willing to tolerate – and STICKING TO YOUR PLAN –  is especially important for those preparing for, and enjoying retirement.

 

This blog post is for informational purposes only.  All investing involves the potential of loss – including invested principal.  Indices quoted are general barometers of security price movement.  You cannot invest directly in an index.  Past performance is not a guarantee of future performance.  This message is NOT personal investment advice and should not be taken as such, nor is it a recommendation to buy or sell any security.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP(R), CERTIFIED FINANCIAL PLANNER(tm) and federally registered CFP (with flame logo) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Investment advisory services offered by Paragon Wealth Strategies LLC, a registered investment advisor.

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