The US debt crisis explained

Getting to grips with the long term implications of the sovereign debt debacle unfolding in the United States Congress involves understanding a lot of “d” words. Here’s a quick cheat sheet to help get you up to speed. The US government runs a budget deficit because each year it spends more than it raises in tax revenue. To fund this deficit, it must go into debt. Congress imposes a limit on how much the government can borrow. If Congress refuses to increase this debt ceiling by midnight next Tuesday, the US government will find itself with insufficient funds to meet regular payments to social security recipients, veterans, et cetera and will most likely default on its interest payments on debt.

This would provoke a downgrade of the nation’s AAA credit rating by rating agencies, which would almost certainly lead to a loss of business confidence and a double-dip recession in the US, and perhaps the world. And that is dumb.

So, has Uncle Sam finally lost his marbles? It does appear the snowy-haired symbol of stern-faced stability has descended into senility, spending more than he earns and not paying his debts. It is a far cry from America’s role over the past half century as the world’s economic superpower.

Indeed, after the dust has settled on next week’s potential default and subsequent credit downgrade, the long run legacy of this bout of Congressional insanity will likely be to accelerate the US greenback’s demise as the world’s reserve currency.

To understand why, you have to go back to fundamentals, about the role of financial markets and the role of the US in them. The financial market is, after all, just a marketplace where some people come to park money and others come to borrow it to do other stuff they want to do. Investors come in search of a safe place to put their money and in the hope of earning a return above inflation. Borrowers just want cash as cheaply as they can get it. The haggling that takes place between investors and borrowers determines the rate of interest one will charge the other.

For many decades, the safest place for investors to park their money has been US Treasury bonds. Bonds are just contracts which stipulate that, in return for an investor’s money, a borrower, such as the US government, will pay a rate of return each year – a “yield” – and eventually give the original sum of money back at some agreed point in the future.

Investors have valued the stability offered by these US Treasury bonds – issued by the world’s most powerful democratic government – so highly that they have been, and still are, prepared to accept an annual return of just 3 per cent to park their money in them, compared to the 5 per cent investors demand from the Australian government.

But this entire system is built on trust – trust from investors that they will be paid a steady rate of return on their money, and, eventually, get it back.

Shenanigans in the US Congress threaten to throw this entire system into doubt. It is hard to overstate the potentially dire consequences that could flow from this.

Worst case scenario, the US government defaults unexpectedly next Tuesday, spooking financial market participants who largely expect Congress will cobble together a last minute deal to increase the debt ceiling. A default could see investors suddenly lose faith in financial markets, withdraw their funds altogether or refuse to lend them at anything but exorbitant rates. Businesses the world over would be starved of funds to do the things they want to do, including employing the workers they need to do it. Economies would shrink, unemployment would skyrocket.

If you think that sounds far-fetched, it’s exactly what happened the day the US investment bank Lehman Brothers collapsed in September 2008.

Most investors doubt things will get to this stage this time around, believing that if Congress fails to pass a last minute deal to increase the debt ceiling, the US President, Barack Obama, will enact powers to unilaterally increase it, or, failing that, issue orders giving priority to interest payments over other payments, such as social security cheques.

But a growing number of economists think the US government will lose its gold-plated AAA credit rating anyway, thanks to the complete lack of a credible plan to bring divergent revenue and spending growth paths back into line.

A lower credit rating would mean the US government would have to pay investors a higher rate of interest on its borrowings.

How much higher is unclear. But any increase would add to the ballooning interest bill the US has already racked up on its debts.

US Treasury bonds have traditionally served as a safe-haven for investors in times of economic uncertainty. But what happens when what investors are trying to hide from is the US itself?

The Australian dollar broke $US1.10 this week in part because investors have already begun the search for alternative safe-havens to US Treasury bonds. (Foreigners can only buy Australian bonds with Australian dollars, so when demand for Australian bonds rises, so too does the demand for Australian dollars, pushing up the price). The escape path towards another traditional safehaven, gold, is already well worn, with gold striking another record of $US1625 an ounce.

Make no mistake; investors, including private banks and central banks, are still buying and holding a lot of US government debt, about $US11 trillion all up. But the scale of the stupidity gripping US Congress is hard to ignore.

The Chinese government has for some time called for a new international currency to replace the dollar, offering the renminbi in its place. As investors watch the disarray unfolding in Congress, they could be forgiven for preferring the strong-armed embrace of a single party state.

This entry was posted in Banks, Budget, Currency, Interest Rates. Bookmark the permalink.

9 Responses to The US debt crisis explained

  1. sandeep s Patil says:

    good article just musing pragmatially God save america!

  2. Sreekant says:

    The crisis has been superbly explained, thanks!

  3. Adam says:

    For a week I have been trying to understand the debt crisis. The news kept mentioning it, and I understood the situation was bad, but I didn’t quite get it. So I decided to search for “debt crisis explained” and among others, found your post, Thanks SO much. It all makes sense to me now! I especially like your first couple of paragraphs with all the D’s.

    Thanks again, and keep posting Jessica!

  4. M says:

    Lovely article. Great job Jessica.

  5. Allen Govender says:

    A brilliant synopsis of the BIG “D”

    Makes sense to me now.

    Allen Govender

  6. good one reg the crisis in US

  7. Debt:

    Debt is neither a defeat nor death. Also, it is neither a disease nor a devil, in most cases it is a status symbol too.

    Coming to realities, debt is an accumulated deficit over a period of time. It is nothing but the inevitable borrowings used for supporting people with health care, education, infrastructure, relief, subsidies, goods and services.

    Thus, nations must stop worrying about debt and start working for rising incomes to meet their peoples’ needs and, there is no point in wasting time and resources on debates and discussions since happiness of the people is the real economy of a nation and the mechanism that makes the people happy is called economics, everything else like GDP, Forex, Sensex and Inflation are nothing but traps.

    Nori Murthy, Author-Norinomics
    Full name: NVSN Murthy, Research Scientist, India
    A temporary visitor on earth serving people and nations

  8. Happiness of the people is the real richness of the nation, everything else like – GDP, debt, economy, economics, inflation, forex, and sensex are nonsensical.

    Nori Murthy, Author-Norinomics
    Full name: NVSN Murthy, Research Scientist, India
    A temporary visitor on earth serving people and nations

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