US Economy- What the S&P Downgrade Really Means

by Dawn Fotopulos on August 11, 2011

There’s an awful lot of hoopla about how Standard and Poors downgraded the sovereign debt rating issued by the United States of America. After all, that debt was considered as risk-free as you could get.

It was the “safe-haven” in an economic storm. It was every certified financial planners advice to purchase these bonds in your investment portfolio once you retired.

Shift the balance away from risky stock market investments, they would say. Buy a government issued bond. The US Government has almost no risk!

First, let’s understand what we mean by “risk”.

Simplifying the world of bonds, when someone, whether it’s an individual, corporation or sovereign nation, buys a bond, it is loaning money to the issuer.

A loan is not a gift. It needs to be paid back at some determined point in time.

There is also a cost to loaning money. The borrower needs to compensate the lender at some rate of return for lending them the money. The lender always has choices as to how to invest, so bond issuers have to make the bonds attractive.

The rating on the bond reflects the risk that the bond issuer will default and not pay the periodic interest to the lenders. The lower the rating, the more likely the default. The lower the rating, the more risk and the more interest the bond issuer has to pay the lenders.

So here’s the rub. The U.S. Government has been on a spending spree that Kim Kardashian could only dream about. The annual deficit or difference between receipts and expenses has gone up four fold in the last two years. We’re now in the “trillions” in debt per year. Wrap your mind around that “T” number because it matters.

It’s really, really expensive to bail out failed enterprises. It started with Fannie Mae and Freddie Mac a few years ago, remember? It was only going to cost $160 billion to save the housing market.

The annual deficit now is over ten times that at a time when tax receipts or government “revenues” are dropping. That was quick work. The deficit increased more in two years than it did over the first two hundred years of our country’s existence.

The only thing that could save the housing market is real demand from people who have real jobs and predictable income. Drop interest rates to zero and the housing market will still crater.

It’s the consumer who is the ultimate arbiter of markets. Without the consumer on board there is no sustainable demand.

Standard and Poors has been vilified in the press.  I say it was high time someone came clean to indicate the risk of paying the interest on our debt has risen dramatically these last two years.

The risk of paying the debt back? Incalculable. We’ll never pay the debt back. It’s simply too large. We don’t have the cash flow as a nation. This is a big deal.

Downgrading US bonds only one grade from virtually risk less, AAA, to more risky but still “investment grade” of AA+ was a gift from God. Keep in mind, most sovereign nations, central banks, and pension funds around the world hold some US debt.

If the risk rises, the interest on the debt rises therefore the bonds fall in value. If you’re holding US bonds right now, you are NOT a happy camper.

That means you’re holding assets that have a higher likelihood of defaulting in the not to distant future if Washington doesn’t get over it’s hangover.

No doubt you’ve heard the US Government will never default on its debt.  The plan is to print money to pay the gargantuan debt obligations. In other words, we’ll use Monopoly money to pay it back.

What would happen if you and I earned $40K per year and we owed $5 M in debt that came due at the end of the year. There’s no way we could pay back our debt. So we decided to go to our copier machine and xerox US Dollar bills, take a scissors, and cut out the bills to pay social security and bond holders.

The money isn’t real. It won’t buy anything. It will continue to take more dollars to buy anything.If you and I did that, we’d go to jail. It’s called counterfeiting. If the government does it, it’s called “Quantitative Easing”.

The jig continues until no one accepts our dollars anymore because they’ve not real money. QE 3 seems inevitable.

Have you bought gas lately? It’s up 60% over 2005. Have you bought milk? It’s up 30% so far this year, and the year isn’t over yet. What happens when the price of gas doubles in a week’s time? An hour’s time?

So gold hit a new high today. Yawn. Anyone surprised? Really. The gaping galaxy that is our deficit, monetary policy that is debasing our currency, rising unemployment, and talks of raising taxes could only mean the shiny metal will rise in price. It’s quite a brew.

The per ounce price of gold is the honest barometer of risk. No government can create it or manipulate it. Don’t you want to know the money you carry in your wallet is real money? Why shouldn’t you be able to exchange it for food when it’s needed whether that’s today or ten years from now? Prices are rising because the currency is failing.

So Standard and Poors got it right this time. US bonds are more at risk of default, plain and simple. Bondholders will want more compensation to hold that risk. The cost of servicing those bonds just went up.

This siphons taxpayer cash away from more productive uses like supporting new business formation, updating our utility  grid, bridges and tunnels and our air traffic control infrastructure. Whatever cash there is is losing purchasing power.

This is a big deal. The numbers are staggering. The US Dollar is being sacrificed on the altar of political expediency and QE 3 is about to make matters worse. If that’s not a default, I don’t know what is.

If you want a little comic relief, read our article on the US Economy, “We Are Sinking”. Watch the video. It’s hilarious.


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{ 1 comment… read it below or add one }

Andi Pema August 16, 2011 at 7:39 pm

Well done Dawn! I liked the youtube representation of 1T dollars. In a visual world it should appeal to both adults and children of the actual size of 1T dollars.

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