April 20, 2011

∴ Warning Shot

An interesting thing happened in the financial markets a couple of days ago. Standard & Poor's, an investment rating company, issued a warning that they might downgrade their credit rating on US debt some time in the next two years, if Washington fails to set forth a plan to reduce that debt. The stock market took a moderate dive in response, because the possibility of a lower debt rating has immense, life-changing possibilities.

The stock decline wasn't the interesting part. The warning was. This is the first time the US has been officially warned about its credit rating by Wall Street.

Companies and governments have the advantage of being able to issue debt by selling bonds when they don't have enough money to cover their outlays. You and I have to go to a bank and ask for a loan. Bond issuers and the average Joe rely on one thing in common, though: a credit rating. The better a debtor's credit rating, the less interest they have to pay on their debt. So a top credit rating makes borrowing, or issuing, debt cheaper.

US bonds are considered one of the safest investment vehicles in the world, because they're backed by the "full faith and credit of the United States."

It is generally accepted that the U.S. government will never default on its loan obligations. The full faith and credit of the U.S. government essentially confers risk-free status to securities such as U.S. Treasuries. (Investopedia.com)

The US government has a AAA credit rating, the highest, and so the treasury can sell bonds that pay less interest than most others and investors will scarf them up. Credit ratings are really a measure of risk. US bonds carry very low risk.

The US has never come close to defaulting on its debt, but with its debt running near 100% of annual domestic production (GDP) and the demonstrated inability of Washington to agree to a plan to reduce it, doubts are beginning to creep in. S&P's warning is the first indication of the possibility of very bad economic times ahead.

If the US debt rating is reduced from AAA to AA, a single step down, the treasury will have to pay higher interest on new bonds in order to entice investors to buy them. More risk requires greater reward. That means the annual interest payments on the debt become even more expensive. And the debt load goes up.

Budgeted net interest on the public debt was approximately $240 billion in fiscal years 2007 and 2008. This represented approximately 9.5% of government spending. Interest was the fourth largest single budgeted disbursement category, after defense, Social Security, and Medicare. (Wikipedia.org)

Interest on the debt, along with all other government spending, is paid with tax revenue. Consider how much more it will cost American taxpayers to service the debt when interest rates climb due to a credit downgrade.

Consider, too, the upheaval in worldwide financial markets as investors begin moving their money, once considered safe, out of US treasury bonds. Perhaps it has already begun. A market awash in US bonds for sale makes those bonds cheaper (greater supply, less demand), so the treasury has to pay even more interest on new bond issues to make them competitive with newly cheaper existing bonds. The cost of servicing the debt spirals upward.

The hard part of getting the debt in control is what needs to be cut from Federal outlays to achieve it. The programs argued over these past few months are chump change compared to the entitlement programs of Social Security, Medicare and Medicaid, and interest on the debt.

Mandatory spending accounted for 53% of total federal outlays in FY2008, with net interest payments accounting for an additional 8.5%. (Wikipedia.org)

and

Several government agencies provide budget and debt data and analysis. These include the Government Accountability Office (GAO), the Congressional Budget Office (CBO), the Office of Management and Budget (OMB), and the U.S. Treasury Department.

These agencies have indicated that under current law, sometime between 2030 and 2040, mandatory spending (primarily Social Security, Medicare, Medicaid, and interest on the national debt) will exceed tax revenue. In other words, all "discretionary" spending (e.g., defense, homeland security, law enforcement, education, etc.) will require borrowing and related deficit spending. These agencies have used such language as "unsustainable" and "trainwreck" to describe such a future. (Wikipedia.org)

There's the source of our debt problem. Who will be the leader who says, "We need to re-organize Social Security and Medicare?"

There are a couple of lights at the end of this tunnel. One is getting a handle on the national debt (something we had in the late nineties), leading us away from calamity. The other is the proverbial freight train of a lower credit rating, upending our (and the world's) economy to a much greater degree than the recent recession.

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