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Far and away, the question I get asked about the downgrade is what does it mean for us in real terms. Like everything else in economics; it requires some explanation and will get you at the end of the day to the trademark economist answer of "it depends."
In Part Two of this series; we broke down the budget in terms of what it would be like if the government were a single household unit living off tax revenue as income and spending money through budgeted expenditures. Because we were spending more than we were collecting in tax revenue; the difference was made up by borrowing. Now, in the aftermath of the downgrade is where it's important to know exactly how we "borrow" money.
Unlike you and I, countries and businesses don't REALLY borrow from each other on handshakes and promises to pick up the first round next time; there has to be a paper trail. As such; federal governments and other business entities issue bonds to account for how much they owe. As some of you may remember from 6th grade Civics class; anyone can buy a bond (you, me, the shady guy that hangs out in your bushes while you shower, and of course, other countries). So, when we say that "China loaned us $100,000 last week"; that means they bought $100,000 of our bonds. Now, for their $100,000 in cash we receive today; they receive some amount that is based on a ratio of time and interest defined in the terms outlined at the time of purchase.
For example. Let's say the above Chinese $100,000 loan is comprised of the purchase entirely in 10-year treasury bonds. The current rate (as of this writing) for that instrument is 2.565%. Therefore, the Chinese can exchange those bonds for $125,650 on August 7, 2021. However, the major distinction between a stock and a bond is that the Chinese can also redeem their bonds for the actual accrued value at anytime before the maturity date. Unlike stocks, Bonds have no risk of loss of principle. If the Chinese wanted to do so; they could buy the bonds today and redeem them tomorrow to earn a whopping $7.26 on their investment; but they'll never LOSE money on the deal (so long as the issuer of the bond remains in existence and doesn't welch on the debt.) This is why bonds are considered a "safe" investment tool.
Now, also like corporations; governments credit worthiness isn't really determined by cash-flow and budgeting issues (at least, not directly). As anybody who has taken a survey level accounting course will tell you; it's more about your general business viability (are you selling a product that people want to buy and doing so in a way that you are profitable long term) that determines if you are a good credit risk or not. Much like Experian, Equifax, and Transunion maintain and evaluate the credit worthiness of private individuals for lenders to determine amounts and rates for mortgages, auto loans, and credit card payments; governments and businesses are monitored and evaluated by Moody's, Fitch and (the folks of the hour) Standard and Poor's (S&P)
Let's consider our previous example:
We've discussed in depth HOW the debt issue got so out of hand so quickly; what we've not really touched on is WHY it was able to happen. Our hypothetical private individual used to symbolize the US was clearly outspending his means; but we never really touched on how they got in that mess in the first place. Imagine if you will that there someone out there in the world who is so credit worthy that lender's from Portland, Oregon to Portland, Maine would send them pre-activated, ready to use unlimited lines of credit on a near daily basis. This man had a good history of paying his bills on time and in fact, lived in the nicest house in the neighborhood. The neighbors who like him, love him, but those who don't; despise his decadent arrogance (but they don't count, because the rest of the neighborhood doesn't care much about them anyway). Anyway; the long and short of the story is that this man has never had a problem securing credit when he needs it; and never really had a problem paying what he owes; because of these two things, he's really stopped keeping a budget all together and is just kind of "winging it" figuring that any problems would work themselves out in time. This cycle went on in perpetuity. . . until it didn't anymore. Things started to go bad for this man; and rather than step back, get serious about getting his financial house in order; he doubled down on borrowing to try and stimulate his household budget. Finally, after about 3 years of this, one of the three credit bureaus dropped his credit score from 850 to 823. (There are 20 levels on the S&P rating system, for those wondering where that number came from). After this happens; as you can imagine; the pre-approved card offers STILL rolled in on a daily basis. However, the man now was puzzled to see that he could no longer just swipe the card and start spending; he had to call and activate it. Even more confusing was the interest rates he was having to pay to use the credit lines. Instead of 2-3% the rates were now 4.5% - 6% (side note, these numbers are completely made up; but I assume in the ball park for what a lender would charge a super-prime credit score individual). In short; the man had just as many people willing to lend him money; but he was having to jump through a few more hoops (and pay a LOT more money) to do it.
Are you starting to get it?
So just like our hypothetical man above; the United States has had one of the three credit monitoring services (called rating services in the treasury world) ding our score. By their completely arbitrary standards and algorithms, they have determined that our financial situation is not as good now as it was the last time they reviewed it; and therefore they are reporting to the World at large that IN THEIR OPINION, they believe that our treasury bonds are more risky now than they were previously. This is important because the whole reason to buy bonds over stocks is to purchase that security against default. With greater RISK of loss, a greater REWARD (called a RETURN in the financial world) is expected.
As such, investors (who tend to have a crazy tendency to base their evaluations in data rather than the promises of politics); are going to expect to be compensated at a higher rate for the money they are parting with today. At a AAA level, meaning the safest haven possible; you can get away with a 2.565% interest rate in a global economic trough; however now that the instrument is slightly less secure; I'll need to be compensated a a higher rate to be motivated to purchase the instrument. What this boils down to for the United States Federal Government at the end of the day is that it plain and simple is going to cost them more to use that increase in the debt ceiling they worked so hard to get. After all; with out it, we ran the risk of being downgraded. . .
(end of Part 4)
(Author's Note: I really was planning for part 4 to be the end of the series; just like I planned for part 3 to be the end of it before that, but this issue is obviously so timely and relevant for everyone right now who I assume cares enough about these matters to read this blog; so plans change. However, I promise that Part 5 WILL wrap this series up and we'll move on to other matters. I have a good 5-7 blogs I want to write that have been percolating for a while now, and I also know exactly how I want the conclusion to this series to end. My hope is to post it Wednesday or Thursday of this week and then we'll move forward. Thank you all for your support in this endeavor. As passionate as I am about these topics, writing 2500 words is a monstrous investment in time and energy; so your feedback and your spreading the word makes it all worth it. I appreciate it and I appreciate you all. . . Tank)
