S&P Downgrade of U.S. Debt and Market Panic of 2011

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Summary:

Author and financial expert, Michael Dallas, explains the causes of current downgrade of the U.S. debt and market panic and how those changes will affect our financial futures.

Video Transcript:

Given the latest string of events, I wanted to publish a detailed commentary. This video includes details on the current downturn as well as an explanation and predictions to how the Standard & Poor’s downgrade of the United States debt will affect your future.

As you know, over the past few weeks, the market has declined significantly with the Dow Jones Industrial Average losing about 1700 points. Last Thursday, August 4, 2011, the market dropped over 500 points and yesterday, Monday, August 8th, the market declined over 600 points. Moreover, the rating agency, Standard & Poor’s, reduced the United States credit rating from AAA to AA+ with a negative outlook.

The two questions I’m being asked are, “should I be worried?” and, “is this a repeat of the 2000-2002 and the 2008 bear markets?” My answer is a resounding, “No.” I don’t believe that there is anything going on that resembles the magnitude of either of those periods.

Remember that both of those down periods were the result of enormous events. The 2000-2002 downturn was largely due to the 9/11 terrorists attacks on New York city. Similarly, the 2008 downturn was the result of the worst banking crisis since the 1920’s. In my opinion, neither the rating downgrade of the U.S. debt nor the European debt crisis rise to these levels.

What I mostly see happening is that Americans are becoming weary and pessimistic. Citizens are worn out from the relatively slow jobs recovery as well as the budget drama in Washington. Against this backdrop, the ongoing European debt crisis and European stock market sell off has rippled panic around the world.

So let’s turn off the cable news channels for a second and look at what is really going on. We need to remember that the economy and the financial system suffered an enormous trauma in 2008. And just like a severely broken ankle, it’s going to take time for the system to heal. The process cannot be rushed.

Let’s look at it another way. In the decade leading up to the 2008 crisis, banks were pouring cash into the housing market. The problem is that an enormous amount of housing was being developed without any real demand for it. Industry, businesses, and jobs were being created around an artificial boom. When the bubble finally burst, the businesses failed and people lost their jobs.

The American system of free enterprise and capitalism is designed to allow failure. We don’t guarantee jobs and we don’t protect businesses. As a culture, we believe that when businesses and industries fail, it is an indicator that capital and jobs need to be reallocated from unproductive activities to productive ones. Many people have called this process the “creative destruction” of American capitalism. Over the long term, it has created the world’s most enviable standard of living. In the short term, it can be a messy and painful process. In the case of the housing collapse, it resulted in millions people suddenly becoming unemployed.

The current high unemployment rate is temporary. With some time, the American economy will recover. Industries will flourish and productive jobs will be created. No matter what you hear on the radio or see on television, the American system of capitalism is robust and will continue to provide a rich environment in which America and Americans can prosper. The fact is that the economy and the number of jobs continue to grow. It’s just not happening as fast as some people would like.

Now, let’s turn our attention to the big news of the day - the Standard & Poor’s downgrade of the U.S.’s credit worthiness. Everyone has an opinion on the problem. Most of these opinions don’t reflect the facts. Over the next few minutes, I am going to leave politics and emotions on the sidelines and explain the issues from a factual point of view.

Before I start, I am going to address the enormous amount of pessimism people feel toward our government right now. Let’s take a step back and look at the situation from a higher plane. We have all heard that the strength of our American democracy is that it is “of the people, by the people, and for the people.” This is absolutely true and it is a beautiful thing. But if we take a closer look, the founding fathers had a very practical purpose in mind for democracy. They wanted a government that could change peacefully.

You see, before democracy, governments frequently changed by violence and force. We’ve all heard the saying, “long live the king.” The people had very good reason for wanting the king to live a long time. At the death of a king, social unrest and civil wars frequently followed. Different factions would try to seize control of the government and in the ensuing struggles, the entire country could be destroyed.

If we look at the war of words going on in Washington in this context, we can see that our system of government is working quite well. No one has pulled out any guns. People are not murdering each other to seize control. The battles, no matter how ugly and fierce, are being fought only with words - not bloodshed and not violence. For this reason, I believe that the messiness of American democracy is not its weakness but its strength.

Now, the path I’m about to take makes me feel like a country preacher I once heard about. You see, the preacher saw that the spouses in his congregation were not getting along. So the next Sunday, the preacher decided to speak about how wives should behave. He preached about how wives should treat their husbands, their children, and their community.

At the end of the service, one of the parishioners came up to the preacher. He said, “you know preacher, I believe that was the finest sermon I’ve ever heard. I’m going to make sure that I’m here next week to hear more of that.”

So the next week, the preacher gave a similar sermon but this time for the husbands. He talked about how husbands should treat their wives, their children, and their community. At the end of this service, the same parishioner came up to the preacher and said, “You know preacher, last week you did some mighty fine preaching. But this week, you done left preaching and gone to meddling.”

In this video, I am going to talk about the two political parties. I am going to stick to the facts and let the cards fall where they may. Please understand that I am not making a political statement nor am I favoring one party over the other. I will let you know up front that I believe that both parties have plenty of culpability in bringing us to where we are today. If at some point, you think I’m picking on one party more than the other, just wait a little bit. I have plenty to say about both organizations.

So, what’s really going on? In two words - entitlement reform. Or to be more accurate, the lack of entitlement reform. For over thirty years, our elected leaders have known with absolute certainty that, without change, our current system of entitlements would bankrupt the country. The reason our leaders have never acted to fix the problem was two-fold. First, it would have meant that a large swath of the voting public would get less in government benefits. Reducing these benefits would have meant the politicians could not get reelected. Second, the day of reckoning over unsustainable entitlements seemed far away and in the future. Political necessity dictated that each new generation of politicians kick the “can” of entitlement reform into the future. Well, the future is now.

Last Friday, a credit rating agency known as Standard & Poor’s downgraded the rating on the United States debt from AAA to AA+. The downgrade was an explicit statement that the new federal budget agreement is not enough to keep entitlements from burying the country under unsustainable debt.

Let’s take a look at what the downgrade means. People have been asking me if the downgrade is “The End of the World as We Know It?” Absolutely not. The 9/11 terrorist attacks in 2001 and the near collapse of the banking system in 2008 dwarf the current downgrade issue. However, there will be some very real and broad consequences.

The most obvious consequence of the downgrade is the effect that it will have on U.S. budget expenditures. An interest rate rise of even .5% (one-half of one percent) would mean an extra $700 billion in additional expenditures over the next decade. This extra spending will just get piled onto the debt making the problem worse.

Less obvious and more important consequences will occur all across the country. A downgrade means that a large raft of other debt based on U.S. creditworthiness will get downgraded as well. Just yesterday, the government backed mortgage debt of Freddie Mac and Fannie Mae were downgraded. What you might find surprising is that over 7000 municipal governments could see their ratings drop as well.

Here’s why. Frequently, municipalities will borrow money at a low rate and then lend it to the U.S. government at a higher rate. The way that the municipality makes money is in the difference in the interest rates. For example, suppose that the city of Hooterville issued $10 million in Hooterville bonds at 2%. (Bonds are simply loans.) Hooterville will then take the $10 million in cash that it gets from the loan and invest it in U.S. Government bonds at 3%. By doing this, Hooterville earns the difference between the rates at which it borrowed and the rate at which it lent. In this case, it is 1% per year on $10 million.

Since Hooterville uses the government bonds as its collateral for its own loan, Hooterville enjoyed the same AAA rating as the U.S. Government. Now that the government debt has been downgraded, the debt of Hooterville will follow suit. In other words, since the federal government’s rating is downgraded, Hooterville’s credit rating could be downgraded as well. Again, it is estimated that 7000 municipalities could see their ratings drop. Obviously, the resulting rise in borrowing costs could weigh on already strapped municipal budgets.

The other effect could come from institutional investors. Many investors such as pensions and foundations are required to hold AAA rated debt. With the downgrade, many of these organizations may need to reorganized their portfolios. Since this has never happened before, it’s not yet clear how these institutional investors will react.

Now let’s talk about the debt itself and examine the problem in more detail. When we talk about trillions of dollars, the number is so large that it really doesn’t mean much to us. So let’s look at the debt in terms of how much federal debt each of us owes. Currently, the debt is $14.5 trillion dollars. If we divide that by the number of Americans, 311,800,000, we find that each baby born in America today owes $46,504 when taking his or her first breath.

So, where does this debt come from? I think we all know. Just like you or me, if we spend more than we take in, we have to borrow the difference to pay our bills. Here’s chart of the federal receipts and outlays. This “gap” is what we call the “deficit.” The deficit is paid for with borrowed money. This borrowed money is our “ national debt.” Just like people who live on their credit cards. The ongoing borrowing and accruing interest makes the debt grow larger and larger.

Now let’s put the debt in perspective. When you and I borrow money at the bank, one of the first questions the bank asks us is how much income have. The bank understands that we need to keep our debts in balance with our ability to pay them back.

As a country, our “income” is known as the “Gross Domestic Product” or “GDP.” It is the sum of all of the earnings in the United States. Just like at the bank, we need to put the size of the national debt in perspective. We need to measure the size of the debt against the size of our income or GDP. This chart show graphs that ratio since the 1950’s. Currently, the national debt represents about 30 some odd percent of GDP. You can see that the ratio has been higher and lower in the past. In general, our current debt load is not excessive. In other words, the amount of our current debt is not the issue.

Here’s the problem. If we don’t change our entitlement programs, the federal debt will begin spiraling out of control in 15 years. The reason Standard & Poor’s downgraded the debt was not that the current debt was too large right now, but that that the recent budget agreement does little to resolve the ballooning debt in the future.

So why is getting the budget under control so hard? Well here’s a quick drawing of how the federal budget is spent - Social Security, Defense, Medicare, Medicaid, etc. Here’s a quick drawing about how the average American views federal spending. Here’s “the stuff that benefits me personally” and here is the “waste.” A lot of people are getting a lot of benefits. To get the budget under control will require a lot of weeping and gnashing of teeth from a lot of voters. Up to now, politicians have not had the stomach to “just say no.”

Let’s look at some myths about the problem The first myth is that welfare is the problem. The fact is that relatively few people get welfare. You can see here that the reforms of the 1990’s to “end welfare as we know it” were successful. In the early 1990’s about 5.5% of the population received welfare. Today, that number has dropped to just over 1%. Likewise, the percentage of the overall budget devoted to welfare programs is relatively small. The fact is that if we completely eliminated the programs we refer to as “welfare” it would have only a marginal effect on the problem.

Let’s look at another myth. For this myth, let me ask you a question. Which administrations added more to the overall debt load - the Republicans or the Democrats? Here’s another chart that shows the federal debt relative to GDP over time. The administrations have been added below. The red swathes are Republican administrations and the blue are Democratic ones.

What we see is that, with the exception of President Obama, every Democratic president since Roosevelt has lowered our relative debt load - Truman, Kennedy, Johnson, Carter, and Clinton all reduced the ratio of debt to GDP.

On the other hand, every Republican administration since Nixon has increased our relative debt load. Ford, Regan, Bush I, and Bush II all increase the amount of debt relative to our GDP. In fact, the vast majority of our debt today can be traced directly to the Regan and two Bush administrations.

How did this happen? If we characterize the Democrats as the “tax and spend” party, then we have to characterize the Republicans as the “borrow and spend” party. The fact is that both parties have been more than happy to spend a lot of money. Republicans have just been more willing charge the spending to the the national credit card.

Now let’s take a look at the federal receipts and expenditures. On the receipt side, you will notice that Social Security taxes and income taxes each represent about 40%% of the federal receipts. Corporate taxes represent 9% of receipts and other miscellaneous taxes represent about 9%. In other words, Social Security taxes and income taxes represent the vast majority of receipts at about 80%.

On the spending side, each category represents about 1/5 of the budget. Medicare represents roughly 20%, Social Security about 20%, defense about 20%, and everything else about 20%. But the future spending of each entitlement varies significantly.

Here is the future budget spending. The green and blue bars are the three entitlement programs - Social Security, Medicare, and Medicaid. The red bar is the interest on the debt. And the white bar is everything else - defense, road building, federal justice system, etc. You will also notice this dotted line. This line represents the amount of tax revenue collected relative to today’s standards. It’s about 20% of GDP. If we trace this line, you can see that by 2030, almost all federal tax receipts will go to Social Security, Medicare, Medicaid, and the interest on the debt.

Let’s look at each of these programs separately. Surprisingly, Social Security is in relatively good shape compared to the others. If we lay a ruler down here, we can see that we will only have to cut future Social Security benefits by roughly 30% to keep spending similar to today’s levels. Likewise, the dark blue bar of Medicaid will need to be trimmed but not too drastically.

What is painfully obvious is the light blue bar. This is Medicare. If we look back to 1970, it was a tiny slice of the overall budget. Today, its about 20%. By 2020 and 2030, the program will consume the lion’s portion of the budget. Few experts serious believe that Medicare as we know it is sustainable.

The next thing we notice is the red bar. This is the interest on the debt. People say that Einstein called compound interest one of the most powerful forces in the universe. Whether he actually said that or not, we may never know. We do know that as interest accrues it begins to snowball. Given enough time, an unpaid debt and its compounding interest becomes enormous. If we don’t come up with a plan to balance the budget soon, the interest expense on the national debt will eventually consume the entire annual tax receipts of United States’ many times over.

So who’s responsible for the entitlements as we know it. The fact is that Democratic administrations presided when Social Security and Medicare were created. And a Republican administration, Bush II, presided when Medicare Part D was created.

Now let’s pause and look at tax rates for just a moment. There is an idea in economics that governments can only extract a maximum amount of money from an economy. To show you why, let me ask you a question. If the government had a zero percent tax rate, what would the government’s revenues be? Zero, of course. Now, as you increase the tax rate from zero to one percent to two percent, etc., government’s revenues would rise.

Now let me ask you another question. If the government had a 100% tax rate, what would the revenues be? Obviously, the revenue would be zero as well. No one would go to work if they couldn’t keep any of their paycheck. This implies that the tax rate can rise to a certain “maximum tax rate.” After that, overall revenues will continue to fall. This idea is known as the “Laffer Curve.”

As a practical matter, when tax rates are high, people begin making decisions to not be productive. A good example would be the Social Security earnings limit. According to the limit, when a Social Security recipient between the ages of 62 and full retirement age works, he or she can earn a certain amount with no reduction in Social Security retirement benefits. Any earnings over that limit reduces the Social Security benefit by $1 for every $2 in earnings. Because this Social Security reduction acts like a 50% tax, most beneficiaries quit working when they reach the earnings limit. For most people, a 50% “tax” is just too much.

Now the optimum point on the Laffer Curve is subject to a great deal of debate by very smart people. So, instead let’s compare the overall tax rates in the United States with the European countries. This is a chart of the rates over time. You can see that the United States historically taxes between 25% to 30% of GDP. The European countries, on the other hand, typically have higher tax rates of 30% to 40% of GDP. Whether taxes could or should be raised will certainly be the subject of vigorous debate in the future.

Now we have reached the part of the program where we ask the Magic Eight-Ball to make some predictions. Understand that the predictions and opinions expressed are solely that of the Magic Eight Ball.

First question. Will this downturn in the stock market be as severe as 2008 and will it last a long time? Answer, “Highly unlikely.” The current market downturn will be temporary. There are no significant structural problems in the economy or financial system. The banks are healthy. The economy is growing. Jobs are being created.

Second question. Will the Social Security program change in the future? Answer, “Yes. For some more than others.” For people who are receiving Social Security now, the biggest change might be in the way Cost of Living Adjustments or COLA’s are calculated. For those born after 1960, their benefits will be about thirty percent less than today’s retirees receive.

Third question. Will Medicare change in the future? Answer, “Yes. A lot.” In its current form, Medicare cannot survive. Medicare probably will not remain a “blank check” “fee for service” benefit. Many ideas are floating about how to reign in the costs of Medicare - block grants, subsidized private insurance, etc. Time will tell what Medicare ultimately will become. But it will change.

Fourth question. Will the budget come into balance. Answer, “Yes. Definitely.” Winston Churchill said, “The American people always do the right thing, but only after exhausting every other alternative.” There is no viable alternative to balancing the budget.

Fifth question. Will a balanced budget amendment be added to the United States Constitution? Answer, “Yes. Definitely.” In 1980, the state legislatures came within two votes of calling a Constitutional Convention to add a Balanced Budget Amendments. In 1995, the House of Representatives passed legislation for a Balanced Budget Amendment. When the measure went to the Senate, it failed to pass by a single vote. The Magic Eight Ball predicts the passage of a Balanced Budget Amendment in the not to distant future.

Sixth question. Will there be political fallout from the downgrade in the upcoming elections. Answer, “Yes. Definitely.” Americans are very proud of baseball, hot dogs, apple pie, and a AAA credit rating. Having that rating lowered has defiled sacred ground. The Magic Eight Ball thinks that American’s outrage will grow over the next two years. Politicians who have been in office for a long time will become the object of that anger.

So, what do we do? Be patient. Stay optimistic. The sky is not falling. In the near future, the stock markets may go up or may go down. We just don’t know day to day what’s going to happen. For those of you who are my clients, you need to remember that we have worked together to put a customized LifeCentric(TM) Wealth Management plan in place. When we do create this plan, we do it knowing that there will be days like these. A down market doesn’t change anything. Pessimism and panic in the markets are going to happen. It’s inevitable. That’s why we prepare for it.

Over the next thirty six months, we will see enormous change in the way our government does business. There will be enormous political change. And, there will be screaming and howling like you’ve never heard before. But that’s okay. It just means the system is working.

I firmly believe that America’s best days are still ahead. And I believe that today is the best time in history to be alive. The way forward for you and me is to remain optimistic and keep everything in perspective.

If you have any questions or if you need anything, call me. I’m here to help.

We’re in this together. I’m Michael Dallas