By Les Dunaway
This is Vol 1 Issue 1 of a weekly discussion intended to lead to better understanding of financial issues facing our country.
I will, each week, take some issue from the current/recent news and discuss the issue itself and how it impacts our country and our way of life. I hope that there will be an ongoing discussion through comments to my posts.
I’m beginning this discussion because I believe that our country is at financial risk because of the bad decisions made in the past. (See below for other writings on this subject) I will stick to the numbers. Fans of Dragnet will recognize my tribute to Sgt Friday in the title. This is a non-partisan issue and if I write anything that sounds partisan, please call me on it. However, when we must discuss specific policies, let’s not yell “partisan” but rather take the Christian approach of “Hate the sin, love the sinner”.
To begin, I want to talk about why I believe our country and our way of life is at risk. At a basic level, it’s simple – no entity, a person, a family, a business or a nation can continue to spend in excess of income indefinitely. At some point, the debt will accumulate to a point where the debt and interest payments (debt service) exceed the amount of the income available after paying basic necessities (disposable income).
This process can be seen easily by looking at a family as an analog to our country. A family must pay for housing, food and clothing1 (necessities). The remaining income is called disposable – that is, it can be spent on whatever the family wishes. When debt begins to accumulate, the debt service eats into the disposable income. At some point, it consumes it. The next step is reducing spending on necessities and the downward spiral begins.
An important concept to grasp is the danger that a family or a country is in when they are just getting by – that is, carrying a heavy debt load but not increasing it while also not reducing it. Which is the story of millions of American families today. The danger comes from interest rate increases. Many of the million foreclosures of 2010 and the million plus ahead resulted from adjustable rate mortgages. What would happen to our country if the massive debt in credit cards suddenly adjusted up? The same can happen to a country that is operating on borrowed money, as ours is.
America’s exposure can be seen by, again, looking at a family. Why do some families get one interest rate on a home mortgage or a credit card and others get a different rate? Because of their credit rating. In the end, your credit rating is the debt industry’s assessment of your the likelihood that you will repay a loan. The difference between your interest rate and your neighbor’s is your risk premium.
So what determines your risk premium? Your past behavior! If you have a history of spending more than your income, your risk premium will be higher. If you’ve been out of work, as millions have and are, you know that your credit rating is, effectively, zero. Existing credit remains in place, with the issuer reducing your credit limit in step with any reduction in balance. However, you cannot get any new credit.
The same thing happens to countries. National debt is financed by selling bonds. The buyers of bonds look at the likelihood that the nation will repay a loan and demand higher interest rates for perceived higher risk. (Since mortgage rates and credit card rates are tied to bond rates, the higher cost of national borrowing hits people with a triple whammy of higher taxes to pay for the borrowing, lost jobs because businesses are hurt by the higher interest rates and higher rates on personal borrowing. This leads to economic crises which further reduce the nation’s credit rating and the downward sprial leads to default, the equivalent of bankruptcy. See “Fund warns U.S. could lose AAA rating“, “Could the U.S. Lose Its AAA Rating Sooner Than Expected?“.
I suggest you read the information about the other nations and see if you can see paralles with America, in terms of the behavior and policies which have put these nations where they are. Ireland is especially instructive because Ireland was the Celtic Tiger a few years ago, until its housing bubble burst â€“ you will find that the policies which led to Ireland’s crash closely parallel the policies which led to America’s recent market crash. Spain is another example of what not to do – see “‘Renewable’ Energy Crisis Sinking Spain”
Next Week: How US states resemble PIIGS
1We can discuss the completeness of this list. However, it is a valid analogy.