U.S. debt currently stands at over $14.5 trillion (which, by the way, works out to roughly $130,000 per U.S. taxpayer). That’s a massive amount of debt.
And if you’ve been listening to the news lately, you’ve likely heard that the Democrats and Republicans are deadlocked over something called the debt ceiling.
I will attempt to explain how this impacts you and your portfolio, but first, let’s start by understanding a few terms.
Government Budget Deficit
Just like you and me, our government too has sources of revenue and uses for that revenue.
In 2010, Federal revenue totaled $2.16 trillion – from income tax (41.6%), payroll tax (40%), corporate tax (8.9%), and custom duties, excise, and estate and gift taxes (9.5%).
In 2010, Federal spending totaled $3.46 trillion – on Medicare (23%), social security (20%), defense (20%), interest payments on debt (6%), and other discretionary expenses such as education and environment protection (31%).
Net-net, in 2010, the government spent $1.3 trillion more than it took in.
Every time a government spends more than it takes in, it runs what is called a budget deficit. In fact, we’ve had budget deficits for each of the past 10 years (well, actually, we’ve had budget deficits every year since 1970 except for four years from 1998 to 2001).
In an unfortunate continuation of over-spending, the Congressional Budget Office estimates a 2011 deficit of $1.5 trillion – the largest ever in U.S. history.
Federal Debt & Debt Ceiling
You might ask, how can our government continue to spend money it does not have, year after year?
Simple… they borrow it, year after year, which is how we’ve racked up $14.5 trillion in debt.
Logistically, the government needs authorization from the Senate and the House of Representatives (collectively, the U.S. Congress) on all borrowings. And total debt cannot exceed a $ limit – the debt ceiling – set by Congress.
The Current Crisis
Traditionally, the Democrats and Republicans have used the debt ceiling to further their partisan causes – be it an increase or decrease in government spending, taxes, etc. -cobbled together a budget compromise both parties can live with, and raised the debt ceiling before the government ran out of money to pay its various mandatory and discretionary obligations.
However, this year, the debt ceiling has become a major point of leverage between the Republicans (who want big cuts in government spending) and the Democrats (who are resistant to certain cuts and wants to raise taxes).
In response, the Treasury Secretary has imposed an August 2nd deadline by when the debt ceiling must be raised to keep the government solvent.
Impact on U.S. Credit Rating
High U.S. debt, escalating political tension on the budget deficit, and the impending August 2nd deadline for the debt ceiling also have credit rating agencies (such as Moody’s) concerned that the U.S. may miss payment of interest or principal on outstanding U.S. government bonds.
As a result, there is some risk that our nation’s credit rating may be lowered a notch from the highest Triple A rating it enjoys today.
Now… a $1.5 trillion budget deficit cannot be erased overnight. High unemployment and predictions of continued near-term economic weakness will likely reduce tax inflows and create a situation where the government has to spend more to support the unemployed – sort of a no-win situation.
Twenty years back the government could have borrowed its way out of its woes, but with our debt as high as it is, we really do not have much room left for maneuvering.
If ratings agencies actually do lower U.S. credit rating below Triple A, the psychological impact may well be worse than the $ impact.
Higher Interest Rates
A lowered rating would mean that the U.S would pay higher interest on future borrowings (same as how you’d pay a higher mortgage rate if your credit was bad). This will flow down and raise rates for individual and corporate borrowings, and adversely impact GDP growth and employment.
High debt levels and continued deficit spending will also weaken the dollar. A weaker dollar means higher prices for all our imports – automobiles, apparel, commodities, computers, electronics, food, gasoline, industrial equipment, toys, wine, and so on.
That means higher gas prices, grocery bills, plane fares, and so on – we will either spend more and save less, or spend less and save more – neither of which are good options because we will have less disposable income… less eating out, fewer movies, trips to the mall, vacations, etc.
All this translates into lower corporate profits, which may dampen stock prices, especially of companies that depend on domestic spending and consumption for most of their profits, such as restaurants, retailers, and domestic airlines.
On the flip side, foreigners may start flooding back to the U.S. on vacations and may step up their purchases of U.S. exports, which could result in related stocks doing well.
In a nutshell, a weakened economy, high budget deficits, sky-high debt, and an impending credit downgrade can adversely impact your savings rate and your portfolio. On the flip side, if you prepare your portfolio for such an event, it could emerge stronger over the long run.
I am pretty confident that neither the Democrats nor the Republicans would want to be blamed for not lifting the debt ceiling. So I believe the ceiling will be lifted by August 2nd.
Before then, investors will have to climb a wall of worry, but an August 2nd deal could see stocks soar into perhaps another rally.
Additionally, the current budget impasse will likely result in reduced government spending and a commitment from both sides to bring down our national debt. This will structurally benefit the US economy over the long run – so stocks, the dollar, Treasury bonds, and our economy as a whole, could well see happier times ahead. So now is a good time to position yourself – while we may get hit by the worst near-term, the best may be yet to come.