How to Protect Your Finances in a Default

Six months ago I thought a federal default unthinkable. Default now seems all too sadly possible. How can individuals protect themselves from the economic consequences of a worst-case scenario?

Some thoughts:

In a default, cash will be worth less (because the dollar will plunge), and debt will cost more (because interest rates will rise). If your situation allows, you should give serious thought to more rapid discharge of debt.

In a default, foreign currencies will rise in value against the dollar (as the Canadian dollar, Australian dollar and Swiss franc have done over the past 30 days). But other so-called hard assets may not do so well. Gold for example is very sensitive to increases in interest rates: since gold does not pay interest, the opportunity costs of owning gold become more onerous if rates rise. Real estate is often thought of as a hard asset, but real estate is also an immobile asset, exposed to the fluctuations of the dollar.

The impact of the crisis on the stock market may be surprisingly muted. Corporate profits have been strengthening this spring and summer, and it is corporate profits that the stock market most fundamentally cares about. Yet individual sectors will suffer: government contractors, obviously; retailers that sell to poorer people who depend on government transfers to support their consumption; and (pay attention to this) banks. Banks have booked great profits by borrowing from the Federal Reserve at almost zero, and then lending to the Treasury at a premium. Money does not get earned easier than that. But in a rising interest rate environment, this carrying trade will be rendered much more difficult.

Foreign stocks will appreciate, or at least seem to appreciate from the point of view of those who bought in pre-crisis dollars. I especially like Canadian bank stocks, they have been the best thing I've bought in the past three years. Too bad the Norwegian oil company is state-owned.

Even a few days of crisis would be a shock to the economy: many people expecting payment from the government will not receive it. If the crisis lasts longer than a few days, the effects will hit harder and harder. The US government is the largest purchaser of goods and services on the planet. If it cuts back dramatically and abruptly, the US economy will plunge back into recession.

One thing I can't figure out: will Congress' decision to rebrand the US as a banana republic be bullish or bearish for banana futures?