Monday, August 8, 2011

What the downgrade of federal debt means to you

800px-USA_Stock_ExchangeWhen the world financial markets open today, it will be the first chance that they have had to react to the news of the downgraded U.S. debt. The announcement of the downgrade by Standard and Poors came last Friday after the close of the markets on a day that had already seen a huge decline in stock markets around the world.

As Georgians learned in 2008, what happens on Wall Street and Washington affects lives in Georgia. The financial crisis that began in New York’s banks and investment houses froze credit in Atlanta and caused the local real estate market to crash. Next, new construction projects stalled and Georgia’s unemployment rate skyrocketed as the effects of the deepening recession spread throughout the state and the country.

The current crisis is different from 2008 in many ways. The debt crisis has been long in coming and was not unexpected. For over a year, rating agencies have warned that a downgrade of U.S. debt was possible if the government did not take steps to reduce borrowing and deficit spending. With the recent debt limit crisis, many investors had already included concerns about the national economy in the value of their investments.

Adding to the seriousness of the new crisis is that, in a flurry of borrowing after congress raised the debt limit, the federal debt exceeded the gross domestic product (GDP) of the entire country. Last Wednesday, August 3, the treasury borrowed $238 billion which put the national debt at over 100 percent of GDP. The last time that the national debt exceeded GDP was in 1947 as the country demobilized after World War II according to Yahoo News.

This will undoubtedly be a volatile day of trading around the world as many investors panic and sell. The fact that the downgrade occurred on a weekend and investors have had two days to calm down may temper some of the trades.

The twin shocks to the market will likely cause more long-term economic damage. As Martin Feldstein, former chairman of President Reagan’s Council of Economic Advisors, recently pointed out in the Wall Street Journal, the Obama Administration’s policies of spending borrowed money and devaluing the dollar have led to the slow growth in GDP. Employment is closely related to GDP. If the economy is not growing, jobs are not being created, and it is difficult for the unemployed to find work.

The Wall Street Journal points out that different commodities may be affected in different ways. Copper, which is used in many products, is considered a bellwether for the economy and is already down eight percent in the past week. This signals fears of a second dip in the recession. Because oil prices often rise and fall with the larger economy, if investors believe another economic downturn is likely oil prices may fall. This could translate into cheaper gas prices for Georgia drivers and lower energy costs. On the other hand, gold prices often rise in times of economic uncertainty. Gold may be driven higher as the debt continues to increase and the dollar continues to weaken. Gold is already trading near record highs.

Another likely effect of the downgrade is a rise in interest rates. For the past few years, the Federal Reserve has kept interest rates low in an attempt to jumpstart the economy. The downgrade means that rating agencies feel that U.S. treasury bonds are more risky due to the increasing federal debt. Since the bonds are more risky, investors are likely to want more interest for loaning money to the federal government (i.e. buying treasury bonds).

According to the Center on Budget and Policy Priorities, six percent of the federal budget is currently spent on interest. If the government has to pay more interest that percentage will grow. If more money goes to interest that means that less money will be available for spending on other programs. This will exacerbate the federal spending crisis.

Adding to the uncertainty is the fact that U.S. treasury bonds are probably still the safest investment in the world, even after being downgraded. This is not so much an endorsement of U.S. treasury bonds as an indictment of the economic status of the rest of the world. The U.S. is broke and dealing with out-of-control spending, but it is still in better shape than Greece, Spain, France, Italy and many other nations around the world. This may mute the effect of the downgrade.

Although no one knows for sure what will happen, the downgrade likely means that the unemployment rates in Georgia and the United States will remain high. Rising interest rates will mean that mortgages and other loans will be more expensive. As interest rates rise on adjustable rate mortgages, there may be more foreclosures. The upward pressure on interest rates will prevent a recovery in Atlanta’s real estate market, which has been hard hit by the recession.

As the borrow-and-spend situation eventually becomes untenable, the federal government will likely be forced to adopt austere spending cuts like those of Greece. This will eventually mean that benefits in the big entitlement programs, Social Security, Medicare and Medicaid, have to be cut. These cuts will affect millions of the poorest Georgians. Other payments from the federal government to the states, such as highway funds, may also be reduced or eliminated.

The United States has reached a point where it is obvious that the federal government must cut spending. As the price of borrowing increases, interest and debt repayment will become ever larger shares of the federal budget. As the economy falters, tax revenues will fall and make the problem even worse. The only solution is to reduce spending without raising taxes, which would also send the economy back into a recession.


Photo credit:  Roland Weber/Wikimedia

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