Standard & Poors on Friday cut the credit rating on U.S. Government debt by one notch from the highest tier.
Since S&P (a company founded in 1860) began rating government bonds, U.S. Treasuries have always merited a AAA rating, so the significance of this event cannot be understated.
Some would argue that this was inevitable, that the U.S. will sooner or later have had no option but to default on its debt, but I do not believe this to be true. I believe that it was the treasonous actions of the Republican Party who, during the recent budget negotiations, allowed the specter of default to become perilously real that prompted this ratings cut.
In other words, the U.S. is now considered less credit-worthy than France, Germany, Sweden, and Canada, of equal credit worthiness to a the communist dictatorship of the People's Republic of China, and one notch above the Italians.
The fact that the United States' fiscal trajectory is on a collision course with ruin is not in doubt. But, up to this point, the willingness of the U.S. to make good on its obligations, as spelled out in the 14th Amendment to the Constitution, has not been questioned. It was the Republican leadership in Congress that openly bandied about the threat of default as a political tool, or perhaps because they would indeed like to squander the good faith and credit of the U.S., that caused the rest of the world to start to question our good faith.
So, what will be the impact of S&P credit cut? Well, that depends in some part upon Moodys and Fitch. If these two agencies follow suit, as they commonly do, then governments and funds who only hold AAA debt will be forced to sell U.S. Treasuries and buy the bonds of other governments. The sale of these bonds will depress the price and raise the yield, forcing the Federal Reserve to increase the note rate on new issuance of debt to attract participants to their auctions.
Since, more or less, all interest rates are linked to the rate on the Treasury Notes, rates such at the Prime Rate and the rate of the 30 year mortgage will go up, thereby exacerbating the fiscal condition of our government and of the economy at large. A higher prime rate will mean that corporate borrowing rates will increase and that more projects will be delayed or cancelled. Higher mortgage rates will mean that buyers on the margin will be refused loans resulting in more contract cancellations and pressure on equity values. With fewer corporate deals taking place and further declines in equity values bank balance sheets will be under increased strain, possibly resulting in the collapse or downgrade of one or more major banks. Since the major banks hold each others debt instruments, the collapse of a major bank could put the reserves of numerous banks below the red line, possibly resulting in FDIC seizure in a cascade that would rapidly exhaust available federal insurance funds.
The Federal Reserve would have no alternative but to print money to cover these deposits, which would further devalue the U.S. dollar and result in an up-tick in interest rates (to combat the perceived inflationary pressure to the underlying currency), which would add fuel to this cascade effect.
Working in the favor of the U.S. is the fact that virtually every country in the world, except Canada, Russia and China, are in the same high debt-to-GDP boat. Therefore, it is not so easy to find alternative currencies to the greenback in which to invest. Additionally, the Chinese need to buy U.S. debt instruments in order to support the peg they maintain on their currency. But, the impacts will be felt nonetheless. Already, Russia and China are piling on their scorn of our profligate ways and it is only a matter of time before this type of talk is followed by posturing. How this might play out can only be imagined, but the fuse will be set making a diplomatic solution to the next crisis that much harder to achieve.
What do I advise that the average citizen do? I advise to vote Democrat in November. We need a monopoly at the Federal level in order to enact the kind of tough measures that need to be enacted to radically alter our fiscal trajectory. Divided government is useful most of the time, but now is not one of those times (I would argue that we should vote Republican, in spite of my resentment of their role in the credit downgrade, if I thought the Republicans had a serious chance of controlling both houses and the presidency, but I don't see that happening). Whether the Democrats have the guts to put a means test on Social Security and Medicare, and cut discretionary spending as they must, we can only hope. But, as long as they can blame the Republicans they won't take the steps needed.
Many people argue that we should be buying gold in times like these, but I view this as being based on a faulty logic, although the recent rise in the bullion would argue that people richer and perhaps smarter than me believe otherwise. I suspect that their expectation is that we will return to the pre-1972 period in which our currency was backed by a fixed quantity of gold held in Fort Knox (the so-called Gold Standard). However, it would be counter-productive for the U.S. to unilaterally return to a gold standard if other major currencies failed to follow because we would be surrendering our ability do devalue our debt while our trading partners devalue theirs. Also, the application of the gold standard would be hugely complicated. For example, it would require that all gold held in private accounts be surrendered to the U.S. Government in exchange for currency whose value is fixed to the value of gold. Secondly, it would require that all U.S. currency currently in circulation be replaced with new currency based on the gold standard; since it is estimated that there is more U.S. currency in circulation outside of the U.S. than here at home, this would pose no small problem.
Therefore, I do not believe that we will return to a gold standard. I hope, however, that we alter our fiscal course expeditiously so as to reduce our debt level to a more manageable level. Getting there will be hard, and it will be reminiscent of life in the United States in the 1930s, in which huge swaths of the country literally scratched a living out of the land. It will be a huge, draconian step backward for many, with personal suffering and possibly even hunger as distinct possibilities, but it will ultimately allow our spending to begin to reflect the realities of our financial condition, from which we can rebuild.
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