A good guy to know knows the basics about some of the terms politicians have been throwing around lately, even if you don’t have a strong opinion one way or another.
What is government debt:
At the most basic level, governments take in money, and then spend it on programs/people. So they take tax dollars from businesses and individuals, and then congress decides how to spend it. So you’ve got money coming in, and stuff you want to spend it on. When the stuff we decide to spend it on, ends up being more than we take in taxes, you have a “deficit.” This is the annual difference between what we spend and what we take in. So the deficit is the annual amount that we are “short.” If you have a bunch of years of deficits, you wind up adding to the national debt.
So instead of putting that ‘deficit’ on a credit card, governments can “issue debt” which is basically the same thing. They get others to give them money, and promise to pay them back at some interest rate. Here’s how the numbers look today:
US income -$2,400,000,000,000
Federal budget -$3,600,000,000,000
New debt – $1,200,000,000,000
National debt – $14,200,000,000,000
Recent budget cut – $38,500,000,000
Let’s take off 8 zeros and make this the Jones family:
Household income -$24,000
Jones’ spent last year -$36,000
Jones’ added to their credit card debt -$12,000
Total credit card debt of the Jones family -$142,000
After sitting around the kitchen table, grinding for weeks on what to
cut from their spending – $385
So in this example, everytime you hear “Trillion”, think of it as $10000 for the jones’ Every time you hear “billion” – think of it as $10 for the jones’s.
Who buys this debt?
Internal Debt – any debt that is owed to lenders within the country 60%
Individuals – savings bonds, college endowments, other institutions, Social security, Military retirement fund, etc.
External Debt – any debt that is owed to foreign lenders 40%
China – 7.5%
Japan – 6.4%
UK – 3.4%
All others – 11.6%
What is a ratings Agency
An organization that gives an opinion of the credit trustworthiness (ability to pay back the loan) and assigns a rating. Just like a credit score individuals, they give a grade to companies/non-profits – and most important to our conversation; governments.
‘AAA’—Extremely strong capacity to meet financial commitments. Highest Rating.
‘AA’—Very strong capacity to meet financial commitments.
‘A’—Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
‘BBB’—Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.
‘BBB-‘—Considered lowest investment grade by market participants.
‘BB+’—Considered highest speculative grade by market participants.
‘BB’—Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.
‘B’—More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.
‘CCC’—Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.
‘CC’—Currently highly vulnerable.
‘C’—Currently highly vulnerable obligations and other defined circumstances.
‘D’—Payment default on financial commitments.
So all of that brings us to today. Where one of the main three credit ratings agencies has downgraded the US’s ability to make its payments from AAA to AA+. Why did they make this decision? Kind of a hotly contested topic, but basically they thought that the US no longer looks like as safe a risk as it has in the past. It’s almost more of a political statement than based on hard facts.
“Since we revised the outlook on our ‘AAA’ long-term rating to negative
from stable on April 18, 2011, the political debate about the U.S.’
fiscal stance and the related issue of the U.S. government debt ceiling
has, in our view, only become more entangled. Despite months of
negotiations, the two sides remain at odds on fundamental fiscal policy
issues. Consequently, we believe there is an increasing risk of a
substantial policy stalemate enduring beyond any near-term agreement to
raise the debt ceiling.”
Why did the markets freak out? – Well actually, they really didn’t. So you’ve heard that bonds/treasuries are considered “risk free.” So basically, when people get concerned about being invested in really risky things, they want to “fly to quality” and this usually means buying a bunch of bonds. As we know from previous podcasts, when a lot of people want something, the price goes up. In this case, the price is the interest rate. So if the market really believed S&P, we would have expected people selling a bunch of bonds and starting to buy some other investment instead, causing the interest rates on treasuries to go up. Instead, as all the stocks started plummeting, the interest rate on treasuries went down to 2.22%, a super low level.
So while the market really seemingly reacted sharply, it almost feels to me like it’s just so sensitive that it’s overreacting a bit and will probably smooth out a bit. Since then we’ve had some more crazy up and down days, and we’ve been here before. Any listeners need to set me straight on anything?