The world is on the verge of a global disaster. Just last week we saw Germany ban naked short selling, a sign that things are clearly only getting worse.
Before that investors around the world started closely watching the Greeks and their fiscal dilemma. That is also when I started watching. Greece was the first sign of a much deeper rooted issue. Greece was just the most over-leveraged of the euro-zone economies, and it revealed that countries similar to it would be endangered as well. If we look with our binoculars we can see that across the pond the whole euro-zone is panicking right now, and as they should be. Excessive budget deficits tend to erode confidence in the government. Whether in the United States or Greece the same principle holds regardless of economic status.
Confidence is very important to financial stability because everything is based off of future profits and cash flows. If confidence in the United States ability to pay back its debts and pay off its treasury notes erodes then we have a problem.
If the United States doesn't bring down its deficit:
A. The ratings agencies will see that debt/gdp ratio is outrageous, and will notice that the deficit is ballooning due to:
1. Lack of foreign demand for domestic goods which leads to decreased tax revenue
2. Rising interest rates since the Fed will have to raise the federal funds rate eventually
3. Reduced government cash flows due to a diminishing tax base with the high unemployment
4. Increased health care costs
5. Increased automatic stabilizers like transfer payments
B. The ratings agencies will then decide to downgrade U.S. Government debt which will lead to:
1. An increased budget deficit
2. Much higher interest rates
3. A massive sell off by all the major holders of U.S. Government debt, ( Many pension and insurance companies have it built into their computers to automatically sell bonds that are not AAA rated)
4. A further downgrade of U.S. debt
5. A massive sell off by China
For those of you who are still skeptical (most of you will be) read this speech by our Chairman of the Federal Reserve, it should help put some things in perspective. One thing to keep in mind is that when the Central Bank Chairman warns about fiscal sustainability it is usually a sign of too little will be done and whatever is done will be much too late in the game to make a difference.
As Ben puts it,
"The path forward contains many difficult tradeoffs and choices, but postponing those choices and failing to put the nation's finances on a sustainable long-run trajectory would ultimately do great damage to our economy."