Debt Limit Crisis: 10 Things That Can Go Wrong

Debt Limit Crisis: 10 Things That Can Go Wrong

Blue Hole Point, Palau By tata_aka_T -

As Senate leaders from both parties are indicating that deal is near to end the partial government shutdown, we take a brief look at what a potential default could mean for M&A and the world economy at large.

  1. A certain recession. Goldman Sachs estimates that sustained failure to raise the limit could result in a fiscal pullback of up to 4.2% of GDP on an annualized basis. In essence, a sustained debt limit crisis could mean a certain recession. Something the US economy can’t afford.
  2. Even Less Funding for Some Sectors. Some sectors of the economy will be hit much worse than other sectors. The sector-wise impact depends on how the executive branch chooses to deal with the default.  Does it make interest payments first to keep the country’s creditworthiness? Does it pay for defense expenses? Does it pay social security or other expenses? Does it pay some obligations in full and only partially fulfil some other obligations?
  3. Uncertainty in the M&A Market. No precedent means the system has never been tested for any of the possible scenarios and their impact on the economy and governance of the country. The uncertainty can take a big toll on the financial markets, consumer sentiment, business sentiment, and the overall economy. None of this is good for M&A activity.
  4. Weaken the Dollar. Uncertainty means higher volatility, higher interest rates, a weakened dollar, and unfavorable currency exchange rates. For an economy that is slowly recovering from one of the biggest recessions in modern history, this uncertainty can be damaging.
  5. Fewer Jobs. Business leaders do not like the uncertainty, because it makes planning difficult. Uncertainty means delayed decisions, curtailed investments, and fewer jobs.
  6. Hamper World Economic Recovery. Given the size of the US economy and its influence on rest of the world, sustained default could also take the fledgling world economic recovery into a reverse.
  7. Destabilize World Financial Markets. The US Dollar is the reserve currency for much of the world, and the US debt is considered risk free and is the basis for world financial transactions. A default on US obligations, even the threat of it, can create substantial uncertainty and can destabilize world financial markets.
  8. One Default Can Mean MORE defaults. Once the precedent is set, the stigma of default may be gone forever. Radicals in the US Congress may be more willing to push the negotiating limits and cause further defaults in the future.
  9. International Defaults. Eurozone and other countries may look at the US default and consider government default as a reasonable option in tough situations.
  10. Sustained Long Term Negative Impact on World Financial Markets. Long term volatility would increase in the financial markets, and long term cost of capital is certain to raise in an environment where even developed countries find it acceptable to default on their obligations.

The uncertainty, volatility, higher interest rates, weakened dollar, and weakened economy all have a dampening effect on the economy and M&A. Business leaders would rather have US default taken off the table and the brinksmanship in Congress come to end.

Mr. Reddy does not own or short Facebook stock and has no material relationship with Facebook. He owns shares of Google.