Young Investor

How the US is living beyond its means

Adarsh Gopalakrishnan | Updated on August 06, 2011


Are the US' foundations too damaged to be fixed?

It is not easy to imagine what it means when a small group of people shout out to the world that the largest country by GDP, the United States of America, is not as credible a borrower as it once was. To those who watch the markets, it may mean red tickers on the screen and hyperventilating traders screaming – Sell, Sell, Sell! That's what has happened with the rating agency Standard & Poor's downgrading US debt just ahead of the weekend. But can one actually draw a parallel between the United States and a metaphor often used by observers, ‘a reckless household'?

The household comparison

Maybe that'll help us understand what this is all about. Start with imagining the opposite - a prudent household. A husband and wife working hard to earn a monthly pay-cheque, which probably goes up every year as they work harder to sharpen their skills and better their economic contribution to society, in the form of taxes and productivity. They sock away a third of what they make as savings and the rest gets spent on essentials such as rent, food, clothing, eating out and so forth. They avoid borrowing except to buy a car they share for work and for the occasional road trip. They hope their savings will one day pay for a comfortable house, fund their child's education or cover some emergency medical spending.

On one of their outings, they spot this gorgeous house; something that comes close to being their dream home. Like a lot of dreams, this too comes with a massive price tag. The couple initially squirm as they're convinced they could never really afford it with their paycheques and the borrowing might choke them. As luck would have the man selling the house is a banker. He tells the young couple, “You've worked hard all these years. You kids should buy it. You deserve this dream house. And I'll tell you what, I'll put in a word with the bank for you.”

Having managed a tight ship so far, the young couple have no trouble getting a fat loan to buy this house. They promise themselves, “We'll make cuts on the eating out, road trips and smartphone upgrades to make this work.” They buy the house.

The young couple move into this palatial behemoth, only to realise, “Wow, its going to cost a lot to furnish this place.” Not to worry! Turns out after the down payment, they still have some savings to dip into. The only problem being their new ‘Grande Palais' needs the teak sofas, ebony beds and LED televisions, and none of these come cheap. Here, comes to the rescue our aforementioned benevolent banker. He says, “Why do you kids worry so much about it? Why don't you borrow some more money to do up the gorgeous house? After all, you are prompt in making the payments for the loan cheques we made to you, so you deserve to make this house look like you dreamt it should. The young couple are a little sceptical, but that's only until the 50-inch LED TV which disappears behind the teak panel is delivered. It was worth it, they decide.

Battered dreams

Having one dream fulfilled, they decide to work on the others. The young man decides he's going to pursue a career in writing, something he's always wanted to do. So he quits his day job that involved assembling and peddling computers. The couple, with very little cajoling from our aforementioned banker, decide to borrow a third time to fix the plumbing and get a fresh coat of paint on their house. After all, the house does deserve it.

A year passes by and the now middle-aged couple are barely getting by after footing the bills. An incident where the young novelist fractures his hand adds to the dilemma and much to his chagrin the work insurance does not cover him. Also, on the list of problems are foundations of their house are weak and the garden needs to be landscaped.

They turn to their trusted old banker. Only this time the benevolent banker decides, “Errr… it's a nice house but you kids were a few days late in making the payment last time, so we might not be able to lend you all you need.” The couple are a little shocked.

Growing obligations

The roles of the young couple and the banker have been essayed by the United States government and a good part of the world respectively. Both seemed to have fitted the part to a tee. The US government over the last nine years has had to borrow to be able to spend on their military, medical and other social obligations.

The receipts which includes taxes paid by individuals and corporates has not been sufficient to pay for the growing obligations of fighting two wars, sustaining an aging population and paying up for a stimulus package, when the economy slowed. The sub-prime crisis which required the country to bail out banks only added to the stress. This was exacerbated by the recession which led to a further dip in taxes paid by individuals and companies to the government. So to make up for the short-fall in income, the government resorted to borrowing increasing amounts from lenders such as China, Russia and pension funds across the world. Little was done to cut spending, partly because it could spell further trouble for the economy.

The recent downgrade by S&P among other others reflect the pressures on the US to either cut down on their spending or raise their receipts with tax hikes. This situation makes markets jittery given that the US accounts for over a fourth of global GDP. That's not all. The dollar is also currency of choice for world trade. Most investors even central banks of various nations have regarded US as the ultimate safe haven and have thus parked a big chunk of their own reserves in it.

That's why the US' credibility as a debtor is crucial to keep the global economic cogs turning. With increasing spending obligations in the form of defence, medical care, and social security, the global markets remain concerned about whether the US can do what it takes to fix its broken foundations or are the foundations too damaged to be fixed. The latter would mean more images of traders screaming ‘Sell, sell, sell' and more red tickers across the world. But what to buy?

Published on August 06, 2011

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