Thursday, July 28, 2011

Actioni contrariam semper et æqualem esse reactionem . . .

Newton's Third Law of Motion: To every action there is always an equal and opposite reaction . . . That's what came to mind with all the chatter about the national debt crisis and the likelihood that the credit of the USA will be downgraded.

As the theory goes, the increased risk that the US will delay/default on payment of its debts caused by the bumbling in Congress will be reflected in a loss of our AAA credit rating among the various ratings agencies.  Action = Reaction.

A downgrading of our credit rating makes US instruments less attractive to investors. Action = Reaction.

A decrease in attractiveness of US instruments requires an increase in interest rates to make the instruments more attractive.  Action = Reaction.

Economics is not Newtonian Physics, but it seems to follow the same natural law.  For every action there is a reaction.

Three years ago we had an alleged "credit crisis" where money available for loans dried up. One would have thought that the natural reaction would have been for interest rates to have gone up to entice people to make loans. Instead the Federal Reserve intervened and started printing money -- loaning it out for a song or outright giving it away.We had "Quantitative Easing (QE) I" and then II pumping dollars into the system. The interest rates that should have gone up were kept artificially low by all the new money the government pumped into the system . . . nice if you were a borrower, but terrible if you were a saver. The value of the money had to decline, too, because if you double the $ supply without a doubling of the economy which backs it up, each dollar represents a smaller portion of the economy.  If money is cheap, it is treated that way, thrown around on risky or nonsense items.

If you constantly spend more than you make, your credit worthiness goes down because it becomes less likely for you to pay your bills on time.  If you have the ability to pay your debts with money that you print yourself, you might get away with it for awhile, but people will eventually figure it out. Your credit worthiness SHOULD go down because you are not returning value for what you initially received. 

Savvy investors, like the Chinese government, have figured this out and have slowly been shedding themselves of US instruments of late because the US has debased the value of its currency with QE I and II. They did not need a ratings agency to tell them what to do.

A downgrade in US credit must occur because the US is repaying its debts with money that is worth less.

While a downgrade would make the US look fiscally irresponsible, it is only because it is true. The good side of a downgrade is that borrowing will become more expensive . . . as it should have become three years ago before the Fed started pumping money into the system. Interest rates may actually return to normal levels from the ridiculously low rates they are at now.

Like Newtonian Physics . . . or Mother Nature . . . government tinkering can only get around the natural laws of Economics for so long.


Dave said...

Nice analysis. And to a certain extent this "crisis" is another bump on the news cycle. Which means we should all be carefully scanning the back pages of the newspapers for the real stories being buried by contrived opera now playing in Washington. You can tell the script is getting out of hand when Pelosi is quoted as saying she's "trying to save the world as we know it."

Anonymous said...

Help me understand. We keep hearing that a downgrade of the country's credit will result "in effect, in a tax increase on everyone" because interest rates will go up for individuals and businesses as well. I'm not sure I understand how the government's inability to live within its means (aka:what it takes from us in taxes)reflects on my history of paying my own bills on time. I understand that there may need to be an actual tax increase so that the government can pay the higher interest on the national debt since the debt won't magically disappear, it will only start costing us more to maintain and we already know that cutting programs and services won't do it all. Only congressional politicians believe that cutting alone will do the job. But, why are we being told that mortgages will cost more and credit card interest rates will go up? Don't we pay those costs to the banks directly for money we use individually? Why is it somehow understood that banks will have to raise individual interest rates if the country's funding sources raise the rates on national debt? Is it because we voted those yahoos into office and now we must pay for our stupidity? Or does the national default trickle down too?