Monday, July 25, 2011

USA Debt Drama

Obama Swims in a Sea of Debt

We have all heard a lot about the current debt crisis facing the USA right now. It has become a daily headline. So has all the bickering between the democrats and republicans about how to handle the situation.

A little background information might be in order for some readers. The US is nearing a debt collapse. The amount of debt the US is allowed to hold at any given time is set in law. Currently, by law, the US is allowed to hold $14.3 trillion of debt. With it's current financial situation, the US will reach this debt ceiling by August 2, 2011.

This allows for 3 possible options.
1) The government passes a resolution to allow for an increase to the debt ceiling, allowing the government to borrow more money to keep things status quo,
2) The government drastically cuts spending, and reassigns existing money from other areas of the budget to pay creditors to avoid a default on debt payments
3) The government does neither of the above and defaults on debt payments, (and likely doesn't have enough liquid capital to continue running as is)

Let's examine each of the following options.

In the past, option 1 has always been the most likely course of action. This is by no means the first time that the government has faced the prospect of increasing it's debt ceiling. In fact, in the last few decades, they have actually allowed a debt ceiling increase nearly every year or two. If you look at George W. Bush's administration, the debt ceiling was increased EVERY year he was in office except for 2, going from $5.9 trillion to more than $11 trillion. Bill Clinton actually did a bit better, only raising the ceiling twice in his 8 years in office from $4.9 to $5.9 trillion.

The only difference as to why we have not heard much about this situation in the past, is that the ruling president's political party controlled the house and the senate, practically ensuring the motion for increase passed. Clearly this is not the case this year, as there is a democrat president, and a republican majority in the house. While it is likely both parties will come to an agreement to increase the ceiling prior to the August 2nd deadline, this year there is an added caveat: an increase to the debt ceiling will likely push the American debt ratio to MORE than 100% of GDP. This would be the first time in history where America will essentially owe more than the nation is worth in fiscal terms.

Option 2 would mean that the acting government puts its foot down and does not allow an increase to the allowable amount of debt, essentially forcing it to drastically slash spending on social programs, likely increasing taxes and reassigning funds that have been allocated to future capital projects (ie, roads, libraries etc) to pay off some of the existing debt in the hopes of not hitting the debt ceiling. This is not a pleasant option, as it means the state of the nation will drastically change, most notably on low income and middle class citizens. Social programs will be massively scaled back if not axed all together, and any tax credits or deductions citizens receive will likely be axed.

Option 3 is the most disastrous. This is where the government runs with the status quo until the debt ceiling is reached on August 2nd. At that point, there is no money left to borrow, and all other income is already allocated. This means the government will default on their debts because there is simply no funds to make debt payments left. This has never actually occurred in US history, and what exactly would happen is open to mass speculation. However, over the last year, we have a better indication as this is the scenario that Greece faced last year. The ramifications will be discussed in detail below.

So, the question is which option will the government choose?

I believe the final outcome will be a combination of options 1 and 2. Government representatives WILL increase the debt ceiling prior to the August 2nd date. But, they will also drastically reduce spending (mostly on social programs) and it is likely that there will be some modest tax increases.

Over the past several months, both republicans and democrats have been fighting over what will be cut, by how much and what the tax increases will be and whom will pay them.

The republican position is that only spending cuts will be considered, and tax increases are simply not an option. Democrats maintain that spending cut are needed, but tax increases to the wealthy and large corporations are necessary to add additional funds to replace some of the spending cuts, lest social programs be decimated and devastate the lower class.
John Boehner: Tough Guy

While there has been significant political posturing from Obama, and more so from republican House Speaker John Boehner, eventually they will have to agree to both cuts and taxes. Cuts will probably be more drastic than the democrats want, and small increases to taxes will occur.

The increase to the debt ceiling will calm international markets for the time being, and the spending cuts will reinforce the nation's current credit rating with international agencies like Moody's. However, there will likely be a small slow down in the American economy until a long term fiscal plan can be set out. We have to remember that spending cuts also means that infrastructure projects like road and highway repair will be scrapped, and this will cause layoffs and less disposable income in the economy.

There is, however, always a small chance that democrats and republicans do not come to and agreement, and option 3 occurs - default. It is likely that international markets would take a beating, and every industrialized nation will suffer the fallout. The US is the world's largest economy. The consumerism of 300 million people creates jobs and investment worldwide. China would suffer dramatically since such a large portion of their economy is manufacturing goods exported to North America. Canada, naturally, would suffer considerably since the US is it's largest trading partner. The vast majority of exports from Canada go directly south of the boarder. Additionally, most large European economies would be otherwise affected by harsher scrutiny from ratings agencies like Moody's. After all, if the economic giant the USA is at risk for defaulting on loans, what chance does Germany, France and Britain have when they are also responsible for continuous bailouts to Greece, Ireland, Portugal and possibly Spain and Italy?

Speculation is just that however. But one thing is certain - the current economic situation of the US is not sustainable. US debt has drastically spiked since the Bush administration - presumably largely due to US military operations in the Middle East. I recommend drastic reduction in the operations of the military abroad. Also, closing many of the tax loopholes for large corporations would be a vast source of additional income. US corporate tax law is some of the laxest in the modern world. These corporations would not likely go somewhere else, as the low tax rates are still favourable, but would also force corporations to pay their fair share.

The world can do nothing but wait and see as the clock ticks down to August 2nd.

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