The Debt Ceiling Isn't the Real Problem

Janet Yellen's strongly worded letters... Common sense and history... Pure brinkmanship... Panic selling? Panic buying!... 'They knew'... The Tullock spike... 'A run on the central bank'... The debt ceiling isn't the real problem...

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Everyone is talking about the debt ceiling these days...

It's all over the mainstream news. And of course, I (Dan Ferris) know my colleague and Digest editor Corey McLaughlin is doing his best to break everything down (like he recently did here and here).

In case you're still unaware, the debt ceiling is a legal limit set by Congress. It establishes how much the U.S. government is allowed to borrow.

The U.S. government hit its current debt ceiling of $31.4 trillion – with a "t," folks! – on January 19. In the four months since then, it has used what it calls "extraordinary measures" to pay the bills.

The debt ceiling hasn't been raised yet this time for a simple reason...

Republicans and Democrats in Congress can't agree on the terms under which they would sign a bill to raise it. Republicans want spending cuts, and Democrats want to raise the debt ceiling without talking about spending cuts.

So the monthslong stalemate continues for now.

On Monday, U.S. Treasury Secretary Janet Yellen sent Congress a letter. It was the fifth letter she has sent to lawmakers since January. (It's just like a bureaucrat to believe she can stave off the apocalypse with a series of strongly worded letters, isn't it?)

In this letter, Yellen told our elected representatives for the second time this month that the U.S. government's "extraordinary measures" could run out as early as June 1. And she ended this one the same way she ended all the others...

Yellen asked Congress to "protect the full faith and credit of the United States by acting as soon as possible."

So now, the whole world is watching the calendar for June 1.

Everyone wants to see if Congress can agree to raise the debt ceiling. That way, it won't need to decide which bills it will pay and which ones it won't.

That's 13 days away.

Of course, what will happen with the debt ceiling isn't really a mystery...

Just use a little common sense...

Look at what Congress has done every single time this issue has come up in the past.

According to the U.S. Treasury Department...

Congress has always acted when called upon to raise the debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. Congressional leaders in both parties have recognized that this is necessary.

That's the whole story right there in one paragraph.

The politicians have always raised the debt ceiling because they know they must. They must raise it because if they don't, the U.S. government will default on its debt – which is considered the safest debt on Earth.

The common sense I referred to a moment ago is simple political calculus. Does either side of the political aisle want to be known as the party that bankrupted the greatest country on Earth?

It doesn't even matter if you think the U.S. is the world's greatest country or not.

That would be among the likely narratives if Congress fails to raise the debt ceiling, causing the U.S. to default on its debt. Each side would blame the other.

As I've said before, it's always somebody else's fault in the "Age of Blame."

The U.S. government's "extraordinary measures" could run out in less than two weeks. But don't panic...

Congress has never failed to raise the debt ceiling. That's because every politician in Washington, D.C., knows their careers would be over if they failed to act.

That tells me the lack of action up to this point is pure brinkmanship...

The willingness to play such a high-stakes game of chicken in front of the whole world is the degree to which each side believes it can spin a narrative blaming everyone but itself for failing to act.

You can get away with that sort of thing pretty easily in the Age of Blame. People expect it. And they don't bat an eye when it happens.

Ultimately, nobody in politics wants this particular stain on their resumes. They know exactly what they're doing. And like everything else they do, this game is purely political.

They might keep the charade going longer than anyone expects – perhaps even into the first week of June or so. After all, June 1 is only Yellen's estimate. The U.S. government is far too big and complex for us to know the precise date of default until it gets closer.

But eventually, they'll raise the debt ceiling because their political careers depend on making promises to voters. And those promises require more borrowing. The U.S. government can't possibly collect enough taxes to pay for all the stuff that elected officials promise to deliver.

So I'm confident that Congress will raise the debt ceiling.

Still, it's always prudent to worry a little bit any time politicians start gambling with other people's lives. And rest assured, if the U.S. defaulted on its debt, very few people on Earth would live their lives without any changes.

The U.S. Treasury bond market is the core of global finance. If it falters, there's no telling what sort of panic and chaos might occur in the world's economy.

When panic takes hold in financial markets, it can become an unstoppable contagion. It can take on a life of its own. And before you know it, everyone and everything is panicking.

In a recent Bloomberg interview that I cited in last Friday's Digest, JPMorgan Chase CEO Jamie Dimon expressed this exact fear. As he explained to the news service...

The closer you get to [a U.S. debt default], you will have panic. And so, the closer you get, you have – markets get volatile... maybe the stock market will go down, the Treasury markets will have their own problems... This is not good. And people must remember, the American financial system is the foundation to the global economic system... and the closer we get, more panic. We might get downgraded.

Now, if you know me, you know that I agree that market panic is a real danger these days.

But right now, I see more panic buying than panic selling...

Big Tech companies are a great example...

Chipmaker Nvidia (NVDA) and social media giant Meta Platforms (META) have both doubled or more since January 1. And recently, iPhone maker Apple's (AAPL) roughly $2.8 trillion market cap eclipsed the market value of the entire small-cap-focused Russell 2000 Index.

Apple is one company. But its market value is greater than 2,000 others combined.

And the reason folks are buying all the Big Tech names again is as dumb as all the reasons they bought the crap out of every tech stock on the planet in 2020 and 2021...

It's because all the Big Tech companies are now seen as ways to play the latest technology craze that will soon magically transform life as we know it, make everyone rich, and turn everything around us into a wonderful utopia...

Artificial intelligence ("AI").

If you haven't used the online AI bot called ChatGPT yet, try it out. You'll want to see for yourself how dumb it is. It's essentially a prettier way of searching the Internet.

Of course, many Big Tech companies are trying to get in the game...

Microsoft's (MSFT) Bing is tied in with ChatGPT. Alphabet (GOOGL) recently rolled out a similar product called Bard. And I'm sure we'll hear about others in the weeks ahead...

Various investors including Bill Ackman, Stanley Druckenmiller, Chase Coleman, and Paul Tudor Jones are taking positions in stocks like Alphabet, Nvidia, Amazon (AMZN), Netflix (NFLX), and other Big Tech companies because of their alleged use and development of AI.

You would think that after getting absolutely obliterated in every tech stock on Earth in 2022, folks would've learned something. But as John Kenneth Galbraith once reminded us...

Financial memory is short.

Ultimately, the stock market is more concerned with the magic of technology than the debt ceiling...

The bond market doesn't look too worried about a looming default, either.

The 10-year U.S. Treasury note yields around 3.6% today. That's noticeably below the most recent year-over-year core personal consumption expenditures ("PCE") inflation level of 4.6%. (Core PCE is the Federal Reserve's preferred inflation gauge.)

Federal-funds futures traders seem slightly more worried. They're pricing in a 25-basis-point ("bps") interest-rate cut from the Fed at its September meeting.

But of course, a 25-bps rate cut is a minor event compared with the U.S. government defaulting on its debt. The futures market likely expects a slower economy, not a default.

In other words, as Corey alluded to in Wednesday's Digest, even the most worried market of them all is assuming a "business as usual" viewpoint. No one believes the U.S. government will default.

But that's the thing about panic...

It's not there until it is. And then, it's too late to fight it.

The banks taught us that lesson a couple months ago...

Most bank stocks had a terrible year in 2022.

Silicon Valley Bank's parent company, SVB Financial (SIVBQ), started last year around $680 per share and finished about $230 per share. That's a roughly 66% decline in a single year!

But even after a decline that big, it still had a market cap of nearly $14 billion when the stock bottomed at around $200 per share in December. By early February, it had rallied as high as $333.50 per share and a market cap of roughly $20 billion.

Heck, just two days before Silicon Valley Bank failed in March, its parent company still had a market cap of about $16 billion. The stock closed at almost $268 per share on March 8. And the bank failed on March 10, rendering its equity completely worthless.

In other words...

Everybody knew Silicon Valley Bank had big problems, but its failure still completely surprised investors...

My guess is that many folks thought the government would save the bank before it failed.

By instituting backstops of all kinds and by doing massive bailouts during the financial crisis, the U.S. Treasury and the Fed taught the world not to worry about big financial risks.

Sure, Silicon Valley Bank became the second-biggest bank failure in U.S. history. Sure, First Republic Bank's failure about seven weeks later bumped Silicon Valley Bank down to No. 3. And sure, Signature Bank also earned the No. 4 spot on the list of bank failures earlier this year.

But before all that, many folks just believed the government would always have their backs.

I'll never forget actor Steve Carell's classic line in The Big Short...

Carell played Mark Baum, a fictional Wall Street hedge-fund manager who was based on real-life investor Steve Eisman. In the final scene of the movie, Baum is sitting outside talking to a colleague on the phone and says...

They knew... They knew the taxpayers would bail them out. They weren't being stupid. They just didn't care.

Baum meant that in the years before the housing bubble burst in 2008, Wall Street bankers sold toxic investments in subprime mortgage securities that they knew were garbage. They did it because they knew when it all blew up, the crisis would be so huge and hurt so many huge financial institutions that the Treasury and the Fed would need to bail everyone out.

That's exactly what happened. And their gambles paid off...

Almost nobody went to jail for any of it (although one Credit Suisse banker did). Bankers got bonuses. Firms got bailed out. And business went on as usual.

It all reminds me of the 'Tullock spike'...

Economist Gordon Tullock developed a famous thought experiment around the time that governments started mandating seat belts in cars.

Tullock suggested that if politicians were serious about reducing traffic fatalities, they shouldn't worry about seat belts. Instead, they should mandate that all cars have a steel spike coming out of the steering wheel.

Of course, that would significantly increase the chances of an accident seriously injuring (or even killing) the driver.

Tullock's idea was based on an economic concept called "risk compensation"...

People tend to behave more carefully if they perceive a higher level of risk. And they behave more carelessly if they perceive less risk.

Safety devices like seat belts, power brakes, and air bags make drivers feel safer. So they're comfortable driving more carelessly.

A spike would be a constant, imminent threat to their lives. And as Tullock reasoned, that would cause them to behave as cautiously as possible at all times.

The Tullock spike also applies to the financial world...

Bailouts and backstops help investors feel safer.

And in turn, that perception of safety causes them to compensate by taking on more risk.

The idea of the Tullock spike was an attempt to use risk compensation to make folks behave more carefully.

A highly regulated financial system like what we have in the U.S. is loaded with measures to protect investors. The fact that those measures work most of the time also means they incentivize investors to take more risks.

Emergency measures from the financial crisis, zero-interest-rate policy, and laws like the Dodd-Frank Wall Street Reform and Consumer Protection Act are all designed to keep folks financially protected from extreme outcomes. They might be able to do that.

But like seat belts and air bags, those same measures also virtually guarantee that folks will become more comfortable taking higher risks.

The most pristine sign of risk-taking comfort in the markets today is bitcoin's latest rally...

The world's most popular cryptocurrency finished last year at about $16,500. It's now around $27,000. That's a roughly 65% gain in less than five months.

Bitcoin tends to trade like a risky tech stock. So the fact that investors love it again today just means that they love the idea of taking a big risk in hopes of making a big gain.

Is that what you would do if you were on the verge of a panic about the possibility of a U.S. debt default?

And no, I don't believe bitcoin is rallying because it would be a good store of value if the U.S. defaults. Stores of value don't generally soar and crash over and over again.

I like bitcoin. I like the idea behind it. But it isn't widely accepted as a store of value – at least, not yet.

Rather, relatively short-term traders dominate the bitcoin market. The crypto's price action makes that clear. It doesn't matter how many people trade or don't trade it. It matters how crazy volatile the price is – and it's insane.

The truth is... most folks wouldn't buy more bitcoin if real panic hit the market in anticipation of a looming default. They would sell it in a heartbeat for U.S. dollars, which is what everybody would want at that moment. They would probably also want to own gold.

The debt-ceiling issue isn't the only thing that could cause panic in the weeks ahead...

In fact, according to hedge-fund legend Ray Dalio, the likelihood that Congress will once again raise the debt ceiling is where our real problems will begin.

Dalio posted his opinions about the debt ceiling on LinkedIn yesterday. As he wrote...

Increasing the debt limit the way Congress and presidents have repeatedly done, and most likely will do this time around, will mean there will be no meaningful limit on the debt. This will eventually lead to a disastrous financial collapse. Why? Because spending more than one earns and financing it with debt, which we have been doing for a long time, is easy, pleasurable, and not sustainable.

Dalio went on to say that central banks must make a choice between two options. And both options lead to a disastrous outcome...

[Central banks] either have to let interest rates rise to balance the supply and demand, which is crushing to debtors and the economy, or they have to print money and buy the debt, which is inflationary and encourages holders of the debt to sell the debt, which makes this debt imbalance worse. In either case that creates a debt crisis that is like the runs on the banks that we have been seeing, but with government bonds being what is sold and the run on the bank being a run on the central bank... That is how all reserve currencies and big debt cycles have ended.

Most folks probably think the idea of "a run on the central bank" is a bit absurd...

After all, central banks don't take deposits the way regular banks do. And even if they did, a central bank could never succumb to a traditional bank run because it could easily print all the money it wanted to satisfy all the deposit holders at any given time.

But I believe Dalio means something else by "run on the central bank." I think he means that central banks will eventually print too much money and cause the value of the currency to collapse.

Whatever Dalio means, it's clear that he thinks such an event is not as far into the future as most folks likely believe. Here's more from his write-up...

We are approaching that tipping point in which the amount of debt sold by the government will be greater than the demand for it, which could lead to the central bank having to print money and buy bonds and a sale of government bonds that would put the central bank in that untenable position I just described.

So I'll leave you with this takeaway...

Maybe the 79th debt-ceiling debate since 1960 is a minor issue. Maybe the politicians will do what they've always done. Maybe they'll save the day again just before the June 1 deadline.

But the real problem goes much deeper than that...

It's the one caused by raising the debt ceiling so many times over the past 63 years. Now, we're faced with an out-of-control level of debt – $31.4 trillion and climbing.

If Dalio is right, we'll soon face a "tipping point" that will destroy the value of the U.S. dollar.

It might not happen today, tomorrow, next week, next month, or even next year.

But we're likely going to stay on our current path of ever-increasing debt. And eventually, we'll reach the point with the U.S. dollar at which "all reserve currencies... have ended."

Maybe that's when investors will finally start to panic.

New 52-week highs (as of 5/18/23): Apple (AAPL), Applied Materials (AMAT), Broadcom (AVGO), Copart (CPRT), Salesforce (CRM), Enstar (ESGR), Comfort Systems USA (FIX), Alphabet (GOOGL), Innodata (INOD), Ingersoll Rand (IR), iShares U.S. Home Construction Fund (ITB), Eli Lilly (LLY), Meta Platforms (META), MSA Safety (MSA), Microsoft (MSFT), Motorola Solutions (MSI), OMRON (OMRNY), Invesco S&P 500 BuyWrite Fund (PBP), PulteGroup (PHM), Spotify Technology (SPOT), and Verisk Analytics (VRSK).

In today's mailbag, a thought about an opportunity in the "chip war," which Corey wrote about yesterday... and some late feedback on our essay from last Friday. What's on your mind? As always, send your questions, comments to feedback@stansberryresearch.com.

"I am just a little guy on the Internet, but if Taiwan makes GOOD chips why don't a bunch of billionaires get together and buy out part of their company, and move it over here, that way the Chinese can't get their hands on some of it... Why not start up a business making chips? If you sign a contract with the gov't (and you know they need the chips) it would pay for itself in a few years.

"[Just my two cents' worth] from a poor retired Navy Chief who operated a Cruiser with two reactors for four years with two tours off the coast of Northern Vietnam." – Paid-up subscriber William L.

"Fantastic article [last Friday], Dan.

"I know now why I signed up for lifetime Extreme Value. You are sensible. Not trying to tease out some insignificant little trend but just look at the numbers in an overall way. I mean does it really matter if inflation according to the nonsense of the BLS measurements are 5.3% OR 4.7%? Really?...

"I've been watching the Fed with you for years and it is hugely aggravating, although I must say I really like Powell and what he is doing. But before that it was a clown show.

"Anyway best of luck in keeping your head on. All the best and thanks." – Paid-up subscriber Al M.

Good investing,

Dan Ferris
Eagle Point, Oregon
May 19, 2023