This past week the markets have been in turmoil and have fallen sharply with the FTSE down by 10% over the last week.
And in my view that’s a good thing.
You see, for too long now the market has been going up (see chart below), it went from around 4500 in May 2009 to over 6000 in January this year. It looked like a bull market despite the fact that the UK economy was in a dire condition.
If you’re an investor this might seem like a very good thing, very impressive growth. Unfortunately, this growth was based on short-term thinking and a perceived worldwide financial recovery while ignoring what’s actually happening in the broader economy.
But short-term thinking isn’t responsible for the current nosedive in the markets, it’s debt that has cause this.
Lots and lots of debt that just won’t go away.
This debt isn’t the fault of company directors or market traders, it’s the fault of governments. This debt is sovereign debt where governments have borrowed more than they can afford to pay back.
A good example is Greece, where they are currently having to borrow 125 billion Euros a year just to help pay for all of the things they’ve committed to spending. And this is a problem for Greece because they owe more than they can hope to pay back any time soon. Government income has gone down and now the country can’t pay it’s debts.
This kind of borrowing is known as a budget deficit: the expenditure of the government is more than the government actually brings in from tax and other revenue, so they’re forced to borrow. Budget deficits are common and not normally a problem if the government can pay and lenders are willing to fork out.
So here’s a quick explanation of how a budget deficit works: Imagine that a government wants to build a major road but they don’t have enough cash in the bank to pay for it. So they ask the markets to lend them money through buying a bond, which is effectively a loan with a given rate of interest. It’s a bit like a mortgage on a house; you don’t have the money in the bank to buy outright so you borrow the amount over a period of years while making regular payment to pay it off.
These bonds can be bought and sold like many other market assets. The government itself guarantees the loan and most governments are seen as ‘safe’ borrowers because governments usually borrow within safe limits and normally don’t go broke.
When an economy is healthy and tax income is enough to pay the loans (and the interest) then everyone is happy. Voters are happy because government spending often creates jobs and the lenders are happy because they are getting their promised return on investment.
However, when the market thinks that a government is borrowing too much or suspects that a government might not be able to pay the loans when promised, the first move is to downgrade the credit rating of that government and increase the interest rate. This then discourages that government from borrowing more because the loan will cost more to pay back.
And this is what has happened to the USA in the last 48 hours. Their credit rating has gone from AAA (the highest rating possible) to AA+ (the next one down). This may not seem like a lot but the US government is now going to have start paying a little more to borrow money and, since they’re borrowing half a trillion dollars a year, that’s going to mean a heck of a lot of extra interest.
The USA has been borrowing almost one and half billion dollars a day (that’s $1.5oo,ooo,ooo) to stay afloat. And over the last week the US Government finally realised that it was unsustainable and they were going to have to either raise the accepted level of borrowing or cut spending immediately. They’ve actually decided to do both, which is a sensible move. Although, personally, I don’t think that they’ll cut spending that much at all.
The problem is that the markets have reacted badly through fears that the USA would default on it’s debts, in other words they might not pay what they committed to when they issued bonds to the markets. The USA has, for many years, been seen as a safe borrower. Now the US government has to realise that they are not bigger than the markets and that debts will eventually have to be paid back.
But who is to blame for the US deficit problem?
Well, during the Clinton administration the US budget was balanced, there was no deficit. But Bush started his wars in Iraq and Afghanistan and borrowed heavily to pay for them, thus putting the United States into debt at levels not seen since the 2nd World War.
And so, over the last few weeks, this uncontrolled borrowing has been brought into sharp focus. The markets have panicked, realising that the market growth over the last few years was based on nothing more than false confidence.
But it won’t be the end of it. This borrowing cycle has to be put to death. In my view governments should only spend what they earn (same with households really). Then your finances won’t be at the mercy of lenders and markets.
Since the beginning of the current credit crunch I’ve become increasingly convinced that governments who’ve been reckless with their finances should be allowed to default. It’ll cause major upheaval in the financial world but only for a short time. The politicians responsible will be quickly ousted, the lenders will realise that governments aren’t the safe borrowers that they thought (and lend more cautiously), and we’ll all have to start living within our means (which has to be a good thing).
But until the budget deficit concept is properly managed, governments can always be held to ransom. And I’m not a fan of that at all.
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