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Debt Limit Jihad

If someone forwarded this to you, you can read about who I am here. I was a strategist and equity partner at the biggest hedge fund in the world. Now I make those thoughts available to you. This Substack grows via word-of-mouth, so please forward to your friends. If you like this writing, you will enjoy my books Master, Minion, and Raising a Thief. This is not investment advice. Investing is risky and sometimes painful.

For inspiration, some things I read this week.

“How do people become cruel and depraved? If you torture someone, are you mad or are you normal? If a white man sets his dog on a black child and everyone says that’s okay, if the neighbors and police and judges and teachers say, ‘That’s fine by me,’ is life worth living? What about the people who don’t think it’s okay? Are there enough of them in the world?”

Deborah Levy, Things I Don’t Want to Know

“I was more taken up with how things actually were than with establishing general laws.”

Czesław Milosz, To Begin Where I Am

I dislike bullies. Though I don’t know what’s worse, the bullies themselves or the people who passively observe their bullying. In the category of bully, I include Congressional debt limit jihadists who, by opposing the US running a budget deficit, are using fear to bully people into their agenda because logic isn’t working.

The overlap between those trying to force a default and election denialism is that the domestic jihadists believe existing procedures are so broken that they need to destroy the system and begin anew. Default and overturning elections are thus extremist means to justify what they believe are noble ends. While they don’t dress the same, in their thinking they are like extremists everywhere—be they 1917 Russian revolutionaries or fanatics in the Middle East.

I have trouble believing this small minority, the core of which appears to be loosely tied to the Freedom Caucus, is dumb enough to want to default, but they could be. Membership in the Freedom Caucus is by invitation only and not publicly disclosed, a secret society.  One of their supposed ilk, Representative Byron Donalds (R-Fl), asserted Biden was “leading our nation to default.”

Debt limit chicken is a classic case of a low-probability event with massive consequences. There have been a lot of such events recently, like the pandemic and Ukraine. I also didn’t think Putin would be dumb enough to invade Ukraine but I still had to protect against the possibility he would by initially reducing and finally selling all of my Russian assets ahead of the invasion. Of course, now I am glad I did. What I thought at the time, December of 2021, might have been an overreaction now looks prescient; Jack be nimble, Jack be quick.

Now I am worried about default and protecting myself as best I can, though it is sort of like trying to protect yourself from a nuclear war, there is no good place to hide. A default occurs when a borrower stiffs a lender.  In this case, mechanically, the lender is anyone who holds US government bonds or T-bills. If the US defaults, these bondholders won’t get repaid, at least not immediately.

Government bonds should be the safest asset. There should be NO default risk. The government owes money in dollars, which they can print, meaning default is theoretically impossible. Because Treasuries are normally the safest asset, they play a critical role in transmitting money.

Ever consider how money actually gets into the economy? The central bank prints it and buys government bonds from a commercial bank. What happens if the Treasury market stops working and these transactions become impossible? I experienced a foretaste last week. I hold some inflation-linked government bonds and for a day there was no market, perhaps an indication that liquidity is beginning to dry up.  

If you default on your mortgage, you lose your house and will have a tough time borrowing for many years. With a government, it is different. The government is the house, so they can’t get evicted.  Yet the consequences of a default are enormous.

As the biggest, most liquid financial market in the world the US is an entirely different category than any other government.  A default would be like the electricity going out, completely. Enormously complicated processes that normally run the in background suddenly grind to a halt. At that point, you see how dependent you were on them. Social security and Medicare payments, banks’ ability to provide credit, among others would seize up. This would bring business to a standstill. Imagine a contractor with short-term upfront cash needs, covered by realized income down the road. All that stops.

None of this needs to happen.


Except that the part of the government that pays off the bonds (the US treasury) needs permission from another department, Congress, to run a budget deficit, a silly feature in the US process. Friday, the US Treasury said they had $88 billion left to pay the bills. There are about $24 trillion in Treasury bonds outstanding.

Given the budget jihadists, the private sector is now buying insurance against a default. Don’t worry about what this literally says, basically when the line goes up (below) it indicates people are worried enough about default they want to buy insurance against it. Mathematically, a 0.7% spread roughly means investors ascribe a 1% probability the US will default.

A default would be a gift for Chinese and Russian propaganda machines. Even the fact that people are justifiably worried is fodder and worrying allies during Biden’s trip to Asia. Beijing and Moscow assert the US is in terminal decline. After January 6, many political leaders in Africa, Latin America, and Europe think the same but are reluctant to say it out loud. The credit crisis of 2008 may in part have given the Kremlin the confidence to seize Georgian territory and a default would seal the argument.

Russia and China have experienced real financial chaos, including default (Russia, 1998) and market suspensions (1917, 1949). This chaos is a core reason why both these places are poorer than the US. Instability is toxic for wealth. Little known fact: Russia’s stock market returns from the mid-19th century until 1917 were roughly equivalent to those in the US! Said differently, under stable, sane administration, Russia could have been about as wealthy as the US is now.

The US foreign policy liturgy is free elections and free, more or less orderly, markets. If the US has contested elections and chaotic markets, the liturgy is tainted, like supposedly holy Catholic priests convicted of abusing children. A robust and principled debate about government spending makes sense. Unemployment is low (3.4%) and the budget deficit is high (5%).

But to meaningfully cut the budget deficit you’d have to make painful choices. It’s like dieting. Drinking a little less Coke won’t do it. You need to cut out all the junk and tolerate some hunger. Liberals will argue we need to cut US military spending, which would work but means handing the Russians Ukraine, and the Chinese Taiwan. Conservatives want to strangle funding for the IRS, claw back Covid spending, block green energy, and stop student loan debt relief. I actually agree with some of their goals, like ending student debt loan relief, but think threatening default is an insane way to accomplish the goal and is not big enough to meaningfully move the needle. Alternatively, we could also do away with Medicare and Social Security and accept that old people will die.  

And, by the way, running a budget deficit is OK, as long a) as it is not too big (it’s probably too big now and fueling inflation), b) the debt is used toward things that will help produce growth in the future or c) it is used to help maintain social stability. For a person, it can make sense to reduce and even eliminate debt. I don’t have any mortgage debt, for instance. But for a government that can borrow in its own currency that is not true, but this is a longer discussion.

Investing – To Navigate Crises You Must Have a (Flexible) Process.

Before I jump into how I am dealing with the above reality, let me provide a window into my process. I traded my first futures contract 22 years ago (1 lot of Canadian dollars!) and have been trading since.  Here is how I make decisions:

a) sketch out a framework and

b) have the flexibility to adjust, and even abandon a framework.

c) and, I know this sounds odd, but listen to the unconscious, which is your inborn survival mechanism.

Apply this philosophy to an article of faith among US investors, which is that stocks are great long-term investments (thus the worship of Warren Buffet). Stocks are great long-term investments. Except sometimes. Like outside of the US. Or the US during a depression when stocks fell 90% and Buffet, if he were investing, would have been wiped out. Or China, or Russia. Stocks are a core part of my asset allocation, but I am also aware they can lead to massive destruction of wealth. Sometimes, rarely. There are lots of logical reasons why this can happen (like a default) but knowing how the framework can break and listening to my unconscious helps me avoid disasters. There have been times when a thought woke me up at 2 am, often an impending risk, and I reduced market exposure. This doesn’t always work but I would not be honest if I didn’t share that it is a part of my process.  

That said, I do operate from a framework. Here is what it looks like.  

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