The Rag Reel


Friday, February 24, 2012

A World Of Credit


Slim-Fast doesn't work anymore!

The Burden of Debt!

   The credit rating of the United States was recently downgraded by Standard and Poor's from AAA to AA+, moving from the best possible rating to the second highest out of 19 possible ratings. The creditworthiness of a government borrower is measured by it's likelihood of default (the inability or unwillingness to repay debts).

   For sovereign nations that issue debt in their own currency, the risk of default is less about the inability to repay as it is whether that currency will be worth the same in the future as it is today. Governments that do not take steps to preserve the value of their currency are - by definition - unwilling to preserve the value of national debt held by investors.

Credit Counts!

   A government can choose to repay its debts by simply turning on the printing press. Today, that can happy electronically in a matter of seconds. But when a government prints more money, that money will soon be worth less. After all, money is a commodity.

   If the supply of a commodity goes up and demand remains constant, the price (value) of the commodity will decline. If supply goes down, the price goes up. It really is just that simple. Unfortunately, the U.S. has been printing a lot of money lately. That devalues our currency, which leads to inflation, less prosperity and less purchasing power.

   To understand why, let's look at what might happen if we allow the U.S. dollar to devalue as a result of government policy. At an exchange rate of 80 yen to the dollar, buying a Toyota Camry for $25,000 gives Toyota the equivalent of 2 million yen. But what if future dollars are worth less and will purchase only 40 yen? At that exchange rate, Toyota would have to double the dollar price of the car just to maintain the same price in yen. This is why when currency devalues, the prices for goods and services eventually increase.

Why Does It Matter?

    Today nearly 30% of all trade is between nations. This trade has not only led to greater global prosperity, but more and better goods, and higher standards of living for billions of people. As a part of this process, capital is exchanged between countries in form of borrowing and direct investing. But when the borrowing goes too far, trouble arises.

   About $4.5 trillion of the $15 trillion in federal debt is held by foreign investors such as China and Japan. If the U.S. dollar is worth less in the future, the willingness of those investors to continue lending will decline. The same will be true for anyone - including employees and retirees -who are paid in U.S. dollars.

   As debt increases, interest rates (the cost of time and creditworthiness) will go up and overall standard of living will decline. After all, the amount of wealth in the U.S is finite. If we must pay more to service our debts, there will be less left over for anything else.

   S&P downgraded the U.S. for one primary reason: the potential inability of the U.S. to repay it's debts with dollars that will be worth the same in the future as they are today. If S&P is right (which I believe they are) and the U.S. government does not start living withing its means, our standard of living will most certainly decline.

Can This Problem Be Fixed?

   Canada lost it's AAA rating from S&P in 1992. At that time, Canada's national debt (measured as a percentage of GDP) exceeded 60%. It took a decade, but the Canadian government was successful in reducing its dependency on debt. Canada's external federal debt-to-GDP ratio fell to 29% in 2002, the year its AAA rating was restored. Canada improved its creditworthiness the old fashion way; by cutting government spending and balancing the budget. When government spending was cut, the economy then grew as amounts previously spent by the government, including interest expenses on debt, were instead invested to improve the capacity and productivity of the nation.

Time To Act!

   Today, the amount U.S. debt owned by third parties is estimated at 73% of GDP. If you include the $5 trillion Social Security trust fund surplus that has also been borrowed by the federal government, the current debt exceeds 100% of GDP. Of course, these calculations don't even begin to include the trillions of dollars in government promises for increased entitlement spending down the road.

   This is why our elected officials and policymakers must act quickly, before our debt grows even more out of control and we see further reductions in our standard of living. The best first step is to reduce borrowing by cutting actual spending - not just the rate of spending increases. All of us need to understand that our fiscal sovereignty is being compromised and that tough choices are required to reverse this trend.

   There are currently 17 nations and three territories (Hong Kong, Guernsey and Isle of Man) with a AAA debt rating from S&P. When the United States of America isn't on that list, it's time for change!

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