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The Great Debt Ceiling Debate – Part 5

This is the fifth and final part of our five part series on the “great debt ceiling debate” written as an accompaniment to our radio show broadcast and podcast, “Raising the Roof – How the Great Debt Ceiling Debate Impacts You”.  You can download the episode on iTunes or find it on our Listen page.

Here we are at our grand finale!  Glad you made it.  Please put on your seatbelt and keep your arms and legs inside the bus at all times.

The Debt Ceiling: What if They Do and What if They Don’t?

For starters, let’s just get clear on what the debt ceiling is.  Since we have people all over the world listening to our podcasts and reading our blogs, we don’t want to assume that everyone understands what the debt ceiling is or even how the U.S. government is organized.  And since there may be a few U.S. citizens who slept through Civics class, it’s probably good to lay a quick foundation.

The debt ceiling is the amount of borrowing the Congress will permit.  Congress (not the President) is in charge of setting the budget.  The President may (and does) submit a proposal, but Congress has the final say.  Then the President’s job is to do what Congress tells him to do.  He’s the Executive, and his job is to execute the will of the people as delivered to him by the people’s representatives, Congress.  Sometimes a President acts like Congress works for him (a dictatorship), or that he works directly for the people (a democracy).  In reality, the U.S. system is really a representative republic.  That’s a whole other discussion, but something you should think about if you’re a U.S. citizen.

Now the Treasury is part of the Executive Branch, so it works for the President.  That is, the Treasury reports to the President, who reports to the Congress, who report to the people.  The Treasury can’t borrow money past the limit Congress says unless the people’s representatives (the Congress) say it’s okay.  What Congress is finding out is that they can’t just say it’s okay if the people (those are the folks who actually have to pay for it all) say it’s not okay.  Right now, there’s a large and loud group of people who are not okay with more borrowing, hence the big debt ceiling debate.

Right now, the Congress has set a ceiling on how much Treasury can borrow, and Uncle Sam has hit it.  If Treasury borrows past that, then the Executive Branch has exceeded its Constitutional authority (like THAT never happens…oops, sorry, did a little sarcasm sneak out?), which, if it happens, would spark a completely different and heated debate.

As stated in our first installment in this series, we’re not here to say what SHOULD happen.  And no one can say with authority what WILL happen.  What we want to do is be prepared for a variety of possibilities. So let’s talk about what some of those various possibilities might be.

What if they DO raise the debt ceiling?

If Congress agrees to raise the debt ceiling, it will rile Tea Party conservatives, but it will calm the markets.  The U.S. will retain its pristine record of having never defaulted.  This may be the closest Uncle Sam has come to defaulting, but it isn’t the first time there’s been a debate about the debt ceiling and warnings from credit rating agencies. Some have said that Uncle Sam’s credit rating is going to take a hit anyway.  It’s something to watch, because a lower credit rating will mean higher borrowing costs for Uncle Sam (higher interest rates paid on Treasury bonds), which means higher interest rates will ripple through ALL types of debt.

One thing new is that with recent financial reform, ratings agencies have less discretion about not downgrading a debt issuer’s rating when problems are apparent.   A problem with the mortgage mess is that the rating agencies overlooked obvious problems and investors got snookered into buying debt that was far riskier than they bargained for.  When the underlying loans started going bad, bond investors got spooked and quit buying.  That meant the flow of money into mortgages stopped, and liquidity drained out of the real estate bathtub causing all real estate “boats” that were floating in that sea of money to drop.

The point is that, like any other borrower, if Uncle Sam’s credit rating drops, then the interest rates he pays will rise.

Let’s stop here and re-visit a previous thought, because it will be part of a recurring theme.

We think Big Ben wants low interest rates because low interest rates will encourage more borrowing and spending, which he thinks is the path to prosperity.  You may or may not agree, but it doesn’t matter what you (or we) think.  Big Ben has the Magic Checkbook (the one whose checks never bounce), so it only matters what he thinks.

So, if anything happens to cause interest rates to rise, the Fed is likely to step in with its Magic Checkbook as “the buyer of last resort” to create demand and bring down interest rates.  And, as we’ve discussed in previous installments, when the Magic Checkbook comes out, inflation happens.  Keep this in mind at all times.

Now, an increase in the debt ceiling means more borrowing, more interest, and more currency expansion.  Why?  Because the open market (think Bill Gross and PIMCO, plus all the warnings from the Chinese) doesn’t appear to have enough appetite for all the bonds Uncle Sam wants to issue at an interest rate that works for Ben and Sam.  So, either interest rates will have to rise to attract more Treasury buyers or the Fed’s Magic Checkbook comes out.  You may have already heard the hints about a possible QE3 coming to a theater near you.

Bottom line:  If Congress raises the debt ceiling, then slow, steady inflation is the best case scenario.  If productivity doesn’t increase (adding more products to the economy) to absorb some of the excess money, prices will rise at a rate that upsets the people and alerts the lenders (the bond buyers) that they’re going to get paid back with devalued dollars.  So slow and steady inflation is the “mandate” that Big Ben talks about all the time.  It’s what he wants to happen.

Of course, if you’re a non-Fed bond buyer (such as China) and you realize the currency of the bond you’re holding (dollars) is dropping by say 5% a year, then you’ll want 5% plus a little bit more to make sure that you really make a profit.  And if you want a higher yield and Uncle Sam needs your money, then either Sam pays or another buyer needs to come in and give Sam a better deal.  Again, that’s when Big Ben steps in with his Magic Checkbook to try and bring yields back down to keep Sam happy, keep bond values worldwide stable (a collapse in the bond market would be a worldwide economic wipe out), and keep interest rates low so consumers can borrow and spend.  Remember, Big Ben subscribes to the notion that borrowing and spending is the path to prosperity.

Yes.  It’s a vicious cycle of persistent inflation.  Go look at a chart of inflation since the U.S. came off the gold standard unofficially in 1933 and then officially in 1971.  What you’ll see is a clear picture of rising debt and rising prices.

What if they DON’T raise the debt ceiling?

There has been a real war going on in the U.S. government about raising the debt ceiling.  What’s all the fuss about?  It isn’t like Congress hasn’t raised the debt ceiling a jillion times before.

It seems that a big and loud faction of the American people is tired of the spending more than you make and borrowing to cover the difference.  There is real pressure on their representatives to stop it.  For them, it starts with refusing to authorize further borrowing.  At least not until an agreement is hammered out as to how to cut spending.

Whatever the details, if the debt ceiling isn’t raised, there are two primary possible outcomes, neither of which is pretty.  And as we’ve already seen, raising the debt ceiling isn’t all that pretty either.  In other words, the U.S. economic picture isn’t pretty, no matter how you look at it.  But remember, inside of all the problems are opportunities, so don’t be discouraged.  Be excited…and keep expanding your education.

So, if the debt ceiling is not raised, then the Fed will need to decide if they want to make the Treasury’s bank account magic also.  That is, the Fed can allow the Treasury to write checks that clear even though there isn’t any money.  This means no default on U.S. obligations.  How can they do that you say?  Well, since the Fed clears the Treasury’s checks, and no one knows what goes on inside the Fed, how would anyone really know when Uncle Sam ran out of money as long as the checks keep clearing?

But overtly giving the Treasury they’re own magic checkbook lets the world know the whole system is a sham, depending on how much visibility anyone has into Uncle Sam’s revenues and expenditures.  Since it’s Treasury’s job to report all of that, we’d guess they’d work to cover it all up.  Some have speculated that it’s already happening.  Who knows?

However, at whatever point the world realizes that the Treasury has a magic check book, investors all over the world will begin to dump dollars and buy stronger currencies and commodities.  Why?  Because they know that spending will continue far in excess of production, and the Treasury can simply expand the money supply at will to cover the deficit.  More dollars out of thin air outpacing production means falling purchasing power (more dollars chasing less goods).  Combine that with worldwide investors dumping dollars, and you have a recipe for hyper-inflation.

Hyper-inflation means that anything denominated in dollars will go up in price fast.  Think Zimbabwe: a trillion dollars for a roll of toilet paper.  Foreigners will be snapping up U.S. real estate (they already are).  And Americans will lose purchasing power all around the world.  Very ugly for Americans and anyone holding dollars.  Look at what gold has done in the weeks leading up to the debt ceiling deadline.  It seems the markets are prepping for long term inflation.

And of course there is the eventual outrage as the American people realize the Executive Branch has now completely circumvented Congress and is at liberty to spend without restriction.  How will the American people respond to that in this age of social media?

Default:  The Doomsday Scenario

The other possibility is outright default.  That is, Treasury will tell the world, “Sorry, I can’t pay you.”

This scenario is being described as financial Armageddon.  Since Uncle Sam has never defaulted, no one can say with certainty what would happen, but common sense says that interest rates would sky rocket.  Why?  Because U.S. debt would no longer be considered risk free and investors would demand a big premium to buy it.

We could speculate on which debt offering would take over as the foundation (“safest in the world”) of all debt risk pricing (interest rates).  But no one knows.  What matters is how the Fed would respond to rising interest rates on Treasuries.

If the Fed is true to form, they will whip out the Magic Checkbook and step into the bond market to create demand in an effort drive interest rates down. Or at least slow down their ascent.

Of course, the amount of Treasury bonds the Fed would need to buy will depend on how the rest of market responds.  But it’s safe to say that it will take LARGE purchases (QE4, 5, 6 & 7?) in order to keep interest rates down.  Remember what that means:  Lots of new money coming into the economy.  It wouldn’t surprise us if they set up straw buyers to hide the fact that the Fed is flooding the system with new money.  But as we said earlier, the excess funds will eventually trickle through the economy and land at the doorstep of the American public in the form of higher prices.

Further, it isn’t likely U.S. productivity could increase enough to offset the volume of new money entering the system, so once again inflation is the likely outcome.  Commodities will spike and prices will rise as the cost of raw materials works their way through the supply chain.

Now you know why Peter Schiff thinks gold will hit $5,000.  It also helps explain why Robert Kiyosaki says “savers are losers”.  Holding dollars in any of the aforementioned scenarios is a sure path to lose purchasing power.  Savvy people will be dumping dollars and purchasing anything real.  Go do a quick study of the Weimar Republic in pre-World War II Germany and you’ll get the idea.  Never in America?  That’s what they said about a default by Uncle Sam.

What’s a Real Estate Investor to Do?

Are you freaked out yet?  You should be concerned and aware, but don’t hit the panic button.  Just keep getting educated, watch the developments, and think through the possibilities.  Then take action as you deem appropriate.  We think you’ll find it helpful to be a part of a “master mind” group of similarly concerned and informed people, so you can discuss issues and bounce ideas off each other.  It’s a big reason why we continue to run our Mentoring Clubs and annual Investor Summit at Sea™.  Look to join or start a group in your area.

As real estate guys, we can no longer just think about real estate outside the context of currency, commodities and Fed policy. Those days are gone – at least in the U.S.

But if we pay attention, then we can use commodities and foreign currencies to protect the value of our cash reserves, go aggressively into debt to acquire properties that will likely increase in dollar denominated value against fix dollar debt (equity happens!), and purchase properties that are most likely to appeal to Americans who are growing poorer, and foreigners who are growing richer.

Take some time and think about that last statement, because that’s there the rubber really meets the road.  We’ll talk more about all this as the weeks and months roll by.  And it will be a major topic of conversation on our 2012 Investor Summit at Sea™, where we will have Robert Kiyosaki with us for an entire week – plus an all-star faculty of experts in a wide variety of relevant subjects.

In closing, let us say that while these are certainly uncertain times, those who are best educated and well-connected will prosper, while those who aren’t are more likely to sell assets, avoid debt and hoard dollars as they’re being squeezed by inflation.  Think through where that will lead. Selling things that are real in order to collect paper dollars which have no intrinsic value and are losing purchasing power.  Does that sound like a formula for success?

Now just one final illustration to make a point, then class is dismissed. Thanks for sticking with us this far!

Imagine if you purchased a $125,000 rental property in a market that produced something the world rally needed- something like oil and gas.  Even if Americans can’t afford much, the hot economies like China will need it and be willing to pay for it.  So it’s likely there will be jobs in any U.S. region that produces energy.  Jobs mean people, and people mean housing.  So an area like that will have a demand for rental housing.  Best, those jobs can’t move away from the region because the product is locked into the land itself.

Now, imagine that you put down $25,000 of cash, which, if left in the bank would go down in value as the dollar falls through inflation.  You get a $100,000 loan at a today’s low interest rates and lock it in for the long haul.  Then you rent the property out for a positive $200 a month.

Big whoop, right?  But at least the property is feeding you and not vice versa.

Then let’s say that you use the extra money to buy a little gold and silver every month.  Of course, you run the risk that the dollar could get strong against gold, so you have to decide what you think is the most likely outcome.  You could also use foreign currencies to hedge against a falling dollar.

Now, doomsday comes.  Zimbabwe-like inflation hits and it now takes $100,000 to buy a loaf bread.  Those $200 a month investments in gold and silver will have held their purchasing power, so you take a small fraction of your gold and COMPLETELY pay off your rental property (not that you would, but you could).

Meanwhile, gas and oil are selling to China so your tenant is earning good money.  Now there’s probably lots of competition for tenants, so your rents aren’t through the roof (though they probably would be thanks to inflation), but you have cash flow.  Or, you have a house that’s paid for that you could live in if you had to.

The point is that the right real estate in the right market, when structured properly, is a great way to benefit from inflation, whether it’s slow and steady (like the Fed prefers), uncomfortable (if Uncle Sam doesn’t slow down the pace of the growth of its debt), or out of control (if Uncle Sam defaults and the magic checkbooks start working overtime).

Your mission, should you choose to accept it, is to understand the economic mechanics of the flow of money and where and how it’s likely to flow. Then position yourself to benefit from as many of the most likely scenarios as possible. As illustrated, we like real estate for this reason.  And if we had time, we could show that even if deflation occurred, you can still win with real estate.  But that’s a topic for another day.

Our Prediction

You thought we forgot, didn’t you?

We think after all the yelling and screaming, that a compromise will be reached and the debt ceiling will be raised.  And whether it comes through a higher debt ceiling or a secret Magic Checkbook in the hands of the Treasury, the U.S. will not default.  Of course, that’s just our opinion and we could be wrong.  We’ll see.

Now take a shower. That was a long workout.  We’re going to buy a bag of popcorn and watch to see how the movie ends.  See you on the radio!

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