Nassim Taleb is back.  Citing a disgust for the lack of effective action on the growing global economic and financial crisis, he’d essentially gone into hiding over the last two years.  (I don’t recall seeing Taleb on TV since May 2010 when he discussed the “flash crash.”)  In fact, his website, Fooled by Randomness, championed this fact (check out the caveat he puts next to his email address at the bottom of the page).

The attached video shows Taleb discussing why he supports Ron Paul for the 2012 Republican Presidential candidate.  He lists four main reasons why: 

1) Paul’s position on reducing government spending in order to decrease the deficit and, in turn, the national debt.

2) Paul’s desire to audit and possibly abolish the Federal Reserve Bank.

3) Paul’s position on America's rampant militarism and defense spending.

4) Paul’s belief that America is resilient and can recover if we commit to rebuilding what was once a vibrant economy.

As the year 2011 draws to a close, I wanted to briefly reflect on the past year and share some thoughts going into 2012.

Twenty-eleven was an eventful year for investors, as we witnessed everything from the Arab Spring uprisings, to a tumultuous summer of debt ceiling debates and credit downgrades, to the continuation of the euro crisis and deterioration of several European countries' finances.  All of these significant, large-scale crises/events should serve to remind us that black swan-style events are more common, and even less predictable, than we may allow ourselves to think, as we seek and crave stability for our financial portfolios.  At the risk of sounding clichéd, we must expect the unexpected.

Twenty-twelve will be no less eventful, considering that the following lies ahead:

1) Presidential election (remember what happened in the 2 months prior to the last one?)

2) Increasing waves of foreclosures in the housing market as Option ARM and Alt-A mortgage rates reset to higher levels

3) Unsettled financial outlook for more European countries that have yet to come into the spotlight (i.e., Spain, France)

4) Congress' continued ineffectiveness at reducing the national debt, cutting spending, or even just passing a budget

5) Possibility of further downgrades to the US credit rating (largely due to item #4 above)

I hesitated to even list these things, as it may come across as forecasting, and we know that doing so is too often a fool's errand -- but I put the list there to simply remind you of the very tip of the iceberg that we can even BEGIN to try to anticipate, all the while knowing that none of these things is guaranteed to come to pass (except #1 and probably #4) and could easily be replaced by other bad news.

While I don't tend to make New Year's resolutions, I do have every intention of maturing and refining my black swan protection protocols for 2012.  I think the stakes for having them in place will be higher than ever, and I'd like to create opportunities to generate some profits as market turbulence occurs.  (Notably, 2011 was the fourth-highest year for 100-point swings [plus or minus] in the market, behind 2000, 2002, and 2008.  I see no reason why 2012 won't compete with these other years.)  I'll be focusing a bit more here on the blog on options strategies and combinations that I plan to experiment with or at least consider in 2012.

Along those lines, I encourage you as the individual investor to commit to a regular schedule or routine of reviewing and closely scrutinizing your portfolios amidst the uncertainty that we're facing.  Set aside some time as frequently as monthly, for example, to check the kinds of holdings you have and what their exposures are to which kinds of risks.  Compare this to what you see and hear in the news regarding government inaction and recklessness, global/market instability, geopolitical pressures, and so forth, and make the best attempt to align yourself defensively towards these risks, while looking for opportunities to benefit where possible and generate profits.  Of course, if you utilize a financial advisor, communicate these objectives and concerns to him or her and ensure they are being addressed.  (While none of what I write is intended as investment advice, I consider the above a common sense approach to investing that any of us could stand to employ.)

Lastly, I want to issue a simple "thank you" to all of the readers and contributors to this site, as I greatly appreciate your interest and passion for this subject.  I wish all of you a safe and prosperous 2012.

Seventy years ago on this day, Japanese armed forces attacked the US naval base at Pearl Harbor, effectively marking the beginning of the United States' direct involvement in World War II.  While we take today to remember this historic and tragic event, I would now submit to you that our country will soon face another Pearl harbor-style event, but this time of the financial sort.

Put another way, we are up against the ever-increasing possibility that our country will suffer a crippling blow financially, with an impact not unlike the Pearl Harbor events of 1941.  The biggest difference may lie in the fact that our country recovered from the Pearl Harbor attack and emerged stronger, something I do not expect will happen now given the dire state of our nation's finances.

A quick summary/reminder of what we're up against:

1) A national debt that now exceeds $15 trillion.  We are paying approximately 3-4% interest on this every year, equating to interest payments of no less than $450 billion.  Servicing this debt will increasingly weigh upon our economy, and force future generations to work harder for less as we struggle to pay the interest alone, nevermind the actual principal.

2) Routine budget deficits totaling over $1 trillion a year, adding to the aforementioned debt.  Our government has promised us way more than they can deliver, and this is evidenced by the fact that every year our budget contains more spending than what we are taking in as a nation.  This is called "living beyond our means."  It's destructive, adds to the national debt, and must stop immediately.  Cessation of deficit spending means we will get less from our government for the same price for a while, but we need to accept that privation and stop selfishly pushing it onto our children and grandchildren.

3) Potential for further credit downgrades, increasing the cost of our borrowing needs.  S&P recently knocked the US credit rating down a notch, resulting in market turmoil, but curiously had no effect on our cost of borrowing.  That won't last forever -- as future downgrades are made, which we know they will be given our government's inaction on this crisis, it will eventually catch up to us and the interest we pay on our debt will go up. This means more of our country's wealth will be needed to make those interest payments, rather than being used for more productive means.

4) Economic productivity that hinges on consumer spending, to the tune of over 70%.  This is unsustainable, simply put.  When almost three-quarters of a nations' economic production is tied to consumers spending their income or going deeper into debt, a day of reckoning lies ahead.  We need to get back to producing exportable goods (read: manufacturing) and making the country more business-friendly, as opposed to forcing those businesses to move their operations overseas.  The obvious question here is, what happens when Americans are so strapped they can't spend anymore?  You guessed it -- the economy goes in the tank.

5) Dwindling job market that practically guarantees lower productivity from a GDP standpoint, declining tax receipts, and a lower standard of living for the American people.  The persistent 8-9% unemployment (and 16+% underemployment) rate says it all -- jobs have left the country and they aren't coming back anytime soon.  This reality has a severe ripple effect, since unemployed people pay less (or no) taxes, spend less money, add less (or nothing) to the nation's economic productivity, which leads to economic slowdown, which leads to more job losses, and so on...you get the picture.

If you listened to my November 27 podcast, you'll recall me saying that our political leadership will not address this financial crisis until it becomes a full-blown catastrophe, as they will then have the political cover to get away with any law or policy they wish to see instituted.  The September 11, 2001 attacks provide the best evidence of this impotent style of leadership, as Congress only passed the PATRIOT Act (albeit a draconian, liberty-killing law in and of itself) AFTER the Twin Towers and Pentagon had been struck, and Flight 93 had been downed -- not before.

Thus, you as an individual investor have to factor into your financial planning the fact that the government will allow this situation to reach catastrophic proportions before acting.  Creating some degree of defensiveness against everything from high inflation, dollar weakness/collapse, and a plummeting stock market would be a minimum level of prudence for today's investor.

Last week, the Federal Reserve announced the next step it planned to take to intervene in the economy and attempt to aid in its recovery.  This step is called "Operation Twist."  I want to briefly discuss it here so you understand what's actually being referred to when you hear this term.

US Treasury bonds range from short term (such as 2 year notes, though there are even shorter terms than that) to long term (30 year Treasuries).  The bonds have price and yield characteristics that move opposite each other (picture a seesaw -- when a bond's price rises, its yield falls, and vice versa).  These characteristics can be plotted along what's called a "yield curve," which under normal circumstances, depicts low yield for short term bonds and high yield for longer term bonds.  The reason for this is, if you buy a short term bond, the duration of time over which you're risking your capital is brief, and therefore lower on the risk scale -- thus, you don't get much yield back for it.  On the other hand, if you risk your capital over a long period of time, say 30 years, you would normally be rewarded for it by receiving a higher yield.

That's under normal circumstances.  We are not operating under normal circumstances.

The Fed has already used various monetary policies to push down interest rates to the 0-0.25% range, which influences the rate at which banks lend to their customers (and which has resulted in historically low rates for borrowers today).  The problem is, there still isn't as much borrowing going on as the government/Fed would like.  The reasons for this are not the point of this article -- suffice it to say that borrowing remains below target.

Enter Operation Twist.  Picture that yield curve again, with the line sloping upward from the 2 year note to the 30 year bond.  If you could grab each end, like a dishrag, and twist it (like you were ringing it out), you'd flatten out that curve.  Yields on 2 year notes would rise; yields on 30 year bonds would fall.  That's the objective behind this policy move.

So how does the Fed accomplish this?  Simple.  The Fed has a certain number of 2 year notes on its balance sheet.  It sells them in the open market.  This increases the supply of 2 year notes, diluting demand and thus lowering the value/price of the notes.  As the price falls, yields rise.

With the money it receives from the sale of the 2 year notes, the Fed enters the 30 year bond market and buys those Treasuries.  As it buys them, supply drops, increasing demand and thus increasing the value/price of those bonds.  As the 30 year prices rise, their yields fall.

Ultimately, as the 30 year bond yield falls, the eventual interest rate you or I might receive on a 30 year loan (read: mortgage) should fall, as well.  At least that's the hypothesis.  Whether banks actually lower the rates any further than they already have (as opposed to just pocketing the wider margin), remains to be seen.

But in the abstract, what does all this really signify?

Desperation.

The government, using the instrument of the Fed, is desperate to juice the economy, by stimulating more borrowing and consumption on the part of the consumer.  Specifically, juicing the housing market has all kinds of (temporary) positive effects on the economy, since so many industries benefit from home construction/remodeling/etc.  Of course, I'd thought we'd already found out in 2007-09 what happens when a housing bubble bursts...but hey let's face it, we don't learn lessons too well around here.

The key point is to see past the fancy jargon and terms of reference that the government and the Fed will throw at you, which only serves to obscure the often negative reality involved, and to understand what is actually happening and how it affects you.

As our economy continues to struggle, with both parties in our political structure pointing the finger back and forth, I thought it might be helpful to dredge up an old article I wrote back during the 2008 Presidential campaign season (located on my previous blog, "Austrian School"), titled "Your Presidential Candidate Doesn't Matter (Subtitle: You'll Be Worse off Economically in 2016 No Matter Who Gets Elected)."

Now, I hate to jump the gun by five years, but I'm starting to feel like I was more right than I even imagined in the first place.  I suspect that if you had read this article of mine when it was first published, at the very least you were a bit skeptical...but now here we are, worse off than we were then, and all signs pointing downward.

While I encourage you to read the whole article, I did want to share and comment on a couple of excerpts here.  To begin:

To quickly summarize: when inflationary policies are instituted, and money is created out of nothing, that money flows to entities that can utilize it before its price-raising effects seep into the larger economy. These entities (investment banks, corporations, the wealthy) can invest it or capitalize it in a fashion that is advantageous to them, such as by investing in real estate, stocks, derivative investments (options, collateralized debt obligations), or anything else for that matter. Then when the added money trickles down to the consumer (read: you and I), we are left with one thing: higher prices. Less purchasing power. Smaller paychecks. Whatever you want to call it, it's not good.

I like this paragraph because it captures, in essence, this prescription we've received of more government borrowing/money printing/spending (through Quantitative Easing I [February 2009], Quantitative Easing II [November 2010], and Operation Twist [September 2011]), which so many of us take for the beginnings of an economic recovery.  Unfortunately, it is actually the poison that will eventually do us in.  It LOOKS good -- "Great! The government is actually doing something, they're helping us out."  It SOUNDS good -- "This government spending will create more construction/infrastructure/etc jobs."  It FEELS good -- "We've GOT to do something, we can't just do nothing."

But it is NOT good, and it will turn out very badly as time goes by.  Briefly said, it will ultimately achieve only the following:

1) Add to the national debt, burdening us with increasing interest payments over time in order to service that debt.
2) Contribute to devaluation of the currency, weakening the value of each dollar, lowering our purchasing power, and leading to a lower standard of living.
3) Crowd out more jobs than it creates; for every job created by the government, the fact that it had to borrow/spend to create it destroys 1+X jobs (we'll never know what the X is).

I also wanted to highlight this excerpt, the closing paragraph of the August 2008 article:

Allow me to proclaim with even more emphasis the following: no matter who becomes President - Barack Obama or John McCain - your economic situation will be worse after the presumptive two terms that individual will serve. By worse, I mean some combination of the following conditions: less home equity, devalued investments in stocks and bonds, lower purchasing power, less available savings, more reliance on credit to buy the essentials, you name it. It won't be pleasant.

Gloom and doom.  Yeah, I know everyone is tired of it, but it's way past the time to face facts.  The government does not have a shred of a clue how to fix the economy, aside from their misguided appropriation of our wealth and the subsequent redistribution of it.  And we see where that has gotten us today.

Actually, it's got to be somewhat unnerving for those who have put so much faith in the government's ability to aid an economic recovery, to see the ineffectiveness of these policies.  I honestly don't know how anyone could actually believe at this point that the government has a viable approach for fixing the problem.  Every policy has failed, and indeed has worsened the conditions under which we're subjected to economically (rising inflation, higher national debt, etc.).

I hate to say it, but at this point in looking ahead to the 2012 election, it really matters not who ends up President.  There is no political will nor ability to compromise on the big issues and problems to suggest that the economy will once again prosper and thrive.  The election season and campaigns will roll on with theatrical flourish, and you and I will continue to witness a declining standard of living.

Followers of this website know that along with Nassim Taleb, Peter Schiff is the other market and investing guru that I follow closely and have a deep respect for -- and so you wouldn’t be too surprised how happy I was to hear that he was given an opportunity to testify before Congress on the current economic conditions.  The testimony occurred back on September 13, and you can watch part 1 and part 2 of his testimony on YouTube.

Basically, Schiff sticks right to the same message that he’s been touting for years, and that he used as a platform for his unsuccessful Senate run in 2010.  The major points you’ll hear in the testimony:

-- The government is a net destroyer of jobs.  For every job we see created in the tangible sense, we have no way of estimating how many jobs were destroyed or stopped from being created due to the burden of higher government spending, debt, taxes, regulation and overall intrusion into the economy.

-- Stimulating the economy with more borrowed or printed money does not make for an economic recovery; rather, it lays the foundation for greater economic pain down the road, by acting as a “sedative” that delays the necessary corrective forces in the market, thus exacerbating them when they finally run their course.

-- Speaking as a businessman (Schiff owns and runs Euro Pacific Capital), he emphasizes the fact that he has been discouraged from hiring new workers due to the high-tax, high-regulation environment our economy is subjected to.  Schiff goes so far as to point out that he has now resorted to opening new offices/branches overseas (he mentions Singapore and the Caribbean) in order to escape the tax and regulatory burden here in the States.  Effectively, these are jobs the government has driven out of the country through various misguided laws and policies.

Of course, these are just a few high points from the testimony.  If you enjoy following Schiff, or want to hear an alternative argument as to how to truly stimulate the economy as opposed to the ones consistently put forth by the government, then I recommend you take a look at the video clips contained in this post.

“Printing money doesn’t deliver a triple-A rating.” -- David Beers, S&P Head of Sovereign Ratings

So the inevitable finally occurred this weekend -- Standard & Poor’s (S&P), one of the the three major credit rating agencies, downgraded the United States’ AAA rating to AA+.  Since the decision was announced, there’s been much wailing and gnashing of teeth at the audacity of S&P for insinuating the US should no longer hold the highest rating possible.  “How dare they” has pretty much been the refrain the last couple of days.

I say, what took them so long?  I mean, let’s face it -- the long term fiscal outlook for the US is awful, simply put.  Consider the following:

-- There’s virtually zero chance the US will ever pay back a single dime on the principal it owes on the national debt.  If I told you I had a couple of credit cards, I max them out all the time, and I never do anything but make the minimum interest payments every month and never pay into the balance, how eager would you be to lend money to me?  Probably not so much.

-- The US has $14 trillion of debt today, but this doesn’t take into account the trillions more coming due at the end of this decade and beyond for all the entitlement programs (Medicare, Medicaid, Social Security).  (I’ve read everything from approximately $50 trillion to over $200 trillion as the total cost of these programs.)  If the Congress and President can barely agree on how to cut $2 trillion (as part of the debt ceiling deal), then what are the chances they can deal with these enormous long term debt obligations?

-- The US economy is headed in the wrong direction, and perhaps permanently so.  The option of growing our way out of the debt problem, by being more productive and increasing the nation’s Gross Domestic Product (GDP), is looking more and more like a pipe dream.  Job growth is stagnant, with nearly one out of every two unemployed persons out of work for six months or more, and the eventual need to raise taxes will stifle job growth even more as businesses retrench.  Since our “productivity” relies heavily on consumer spending, a slowing economy and more limited borrowing ability (as a result of the credit downgrade) will further hamper any rise in GDP.  As GDP remains level and debts rise, our overall debt-to-GDP ratio will soar, a key aspect of the S&P decision.

To back up for a second, it’s important to understand what S&P is actually rating.  The grade they assign indicates the likelihood that the entity issuing the debt will pay back the obligation. At the same time, the rating tells the debt purchaser how much risk it is assuming in the transaction.  So the rating is intended to synopsize the long-term debt outlook for the entity being rated.  As the rating declines, debt purchasers can demand higher yields (interest rates) on the debt in order to compensate for the higher risk associated with the debt issuer, thus making it costlier for the issuer to borrow money.

What does this all mean to us as individuals in the US economy?  Well, as the US government’s borrowing costs rise, banks will raise their interest rates commensurately to keep up with the trend.  When banks raise their rates, this will affect everything from mortgages, to school loans, credit cards, personal loans, car loans and so forth.  You will eventually pay more interest to borrow money compared to today.

The credit downgrade signifies a sad day in our country’s history.  Once a great economic power, we’re now left in a position where our debt instruments are no longer considered the safest available.  We held that status for 94 years (since 1917), and never held a rating below AAA -- until now.   Some will have the urge to blame this development on the President, or his predecessor, or this Congress -- but the bottom line is the problem has been fomented over numerous decades.  Only now are we seeing a symbolic representation of this decay in our fiscal position as a nation.

Unfortunately, it probably won’t stop here.  With our long term debt outlook deteriorating year over year, S&P has indicated more downgrades may be coming.  With our debt-to-GDP ratio  projected to hit 101% ten years from now, such a development would warrant another downgrade, this time to AA status.

The best advice I could give right now is to liquidate as much debt as possible, as quickly as possible (assuming you have any).  While the downgrade’s effects could take years, you won’t be able to time when those effects hit, so you need to be protected well in advance.  In addition, as always, review your portfolios for exposure to assets that would most likely be weakened by the downgrade, such as the US dollar and US Treasury bonds, and hedge or short (bet against) these positions appropriately.  Again, the effects won’t come overnight, so you have to decide when the timing works best for you and your particular situation.

What are your thoughts on the downgrade?  Please leave a comment below or contact me directly.

Back on May 26, I blogged about how the raising of the debt ceiling is a foregone conclusion.  I podcasted on it last week as well.  I'm posting this brief article as simply an update for those of you who weren't as tuned into the debate back then (I don't blame you, this stuff is painful to watch/follow), but now find themselves drawn into the inanity of it all.

Building on the May 26 post, I assert here that Congress never had any serious intention of reforming anything with our national debt or deficit as a result of the debt ceiling situation -- and this is precisely why the ceiling would be raised.  No hard decisions would be induced, no tough medicine for anyone to swallow.  In the absence of that, the outcome is clear: the government as a whole -- Congress and President -- would collectively find a way to delay the inevitable, yet again, and thus make that inevitability that much more painful when it finally arrives.

Don't get me wrong -- there was some tough talk that initially appeared promising.  Talk of a "grand bargain" that would cut $4 trillion of spending over the next several years; proposals that would initiate the difficult yet necessary job of reforming our bloated entitlement programs; and claims of politicians being willing to finally make the tough calls and in turn, receive heat from their respective political party.

And yet now we're told that the fallback plan, presented by Republican Senator Mitch McConnell, which would allow the President to have the ad hoc authority to raise the debt limit autonomously and then allow a symbolic series of votes on it by the Congress in order to record opposition, is gaining steam as time runs out to the August 2 deadline.

Surprise.  The government has failed to act responsibly, again.

But isn't that how the story always ends?  So there are really no surprises here, just more of the same as the country's finances swirl into the depths of the toilet.

To the Congress, I'd like to issue the following challenge going forward: instead of debating who you are going to tax to make up for your mistakes, or debating whose social program you're going to cut to reduce spending (however necessary either of these actions may now be), how about turning the debate towards limiting your own powers to create these messes in the first place?  Here are some points of debate I challenge Congress to take up:

-- Institute term limits on all Representatives and Senators.  Remove the incentive that drives politicians to make a career out of lying and stealing.

-- Make an unbalanced federal budget illegal.  (Perhaps a Constitutional amendment would achieve this, though I'm not sold -- Congress already ignores most of the Constitution anyway.)  Cut off the temptation to rack up deficit after deficit in every budget year.

-- Abolish the Fed.  It's stated objectives are twofold: stable prices and low unemployment.  Grade for each of these: F and F.  Dollar has lost 90+% of purchasing power since the Fed's inception -- I don't call that price stability; and numerous boom/bust cycles fueled by Fed monetary policy have created too-long periods of high unemployment.

I look forward to your comments and questions on the debt ceiling debate.

Nothing more, nothing less.  The ongoing debate in Congress about whether the debt ceiling should be raised or left at the present level of $14.3 trillion or so is in and of itself a waste of taxpayer money.  We all know the outcome, but for some reason we have to go through the motions of acting like our elected officials are going to actually do something about this problem.  The reality is, the debate will go on for as long as it possibly can (about another 10 weeks or so until the limit is breached), and then the ceiling will be raised.

(The debt ceiling, or limit, is established in law, and is the cap that the government puts on its borrowing level.  The limit currently stands at $14.3 trillion.  To date, standard procedure for Congress when reaching the debt ceiling is simply to raise it.  It’s like the limit on your credit card, only every time you reach it you just call your bank and they raise it some more, so you can keep on borrowing and spending.)

I’m saying it here, now, on May 26 on my blog -- there is a 100% chance the debt ceiling will be raised.  I don’t need to watch any news clips, review and analysis of Congress’ machinations, or anything of the sort.  It’s a done deal already, before we even arrive at the ceiling.

Why?  Because our country is addicted to debt/consumption/borrowing/spending.  We’re not going to stop spending.  The public demands it.  Congress needs it for reelection.  Our economy thrives off of it.  It will go on, until it can’t go on anymore.

One great piece of evidence of this fact is the recent discussion on the Paul Ryan (Republican representative from Wisconsin) budget plan, which included the controversial proposal of turning Medicare into a voucher program for individuals under age 55.  Generally speaking, this means that instead of the government picking up the tab for your medical bills, you’d be given a lump sum subsidy to allocate towards insurance coverage of your choosing.  My understanding is that if the subsidy didn’t cover the bill, you’d be left to pay the difference.  Of course, the phase-in for the under 55 crowd would theoretically allow for those individuals to make other arrangements to augment their Medicare subsidy, while those over 55 would still be covered under the old program as they’d have less (or no) time to adjust to the new program.

Say what you will about the Ryan proposal -- I don’t know it inside and out, and even then I can say that I’m sure it’s far from perfect.  But if it’s nothing else, it attempts to do what no other plan seems to be willing to do, and that is to make the hard choices necessary to change a program that simply can’t exist in its current form.  Medicare has to change -- the question is, do we change now and suffer the pain, or change later and incur even more misery as the problem morphs into a crisis.  (I say “change” and not “fix” because we can’t say whether the Ryan plan would actually fix the program. Unintended consequences of his plan could simply leave us with a new set of dilemmas to face, which is often the case whenever the government gets involved in anything.)

This week, the Senate voted on the Ryan plan and defeated it.

So we needn’t look any further than the Ryan plan to understand the spending addiction is too great, too deep-seated to be undone now.  As an individual investor, you should be planning for scenarios that include continued high levels of government borrowing and spending into the foreseeable future.  Commensurate with that, your planning would then include rising interest rates, a weakening dollar, rising commodity prices, and even eventual replacement of the dollar as the world’s reserve currency.

The one thing you don’t need to waste your time with is following the debt ceiling debate.  It’s theater, pure and simple.  Republicans, who appear to be holding fast to the notion that they’ll vote against a raise in the debt limit unless significant spending cuts are instituted, will ultimately bow to the political pressure associated with being responsible for cutting off the gravy train of spending and consumption.  Democrats will allege that Republicans want to cut off funding for critical social programs (such as Social Security and Medicare), and that’ll do the trick to derail any serious discussion on spending cuts and the debt ceiling.  

Mark your calendar for early August -- that’s when the debt ceiling will be raised.

Earlier this week, the Standard & Poor’s (S&P) credit rating agency issued a downgrade on the United States’ debt outlook.  The US debt rating, which had stood at AAA stable, was modified to AAA negative.  We’ll look at what that means specifically in a moment, but conceptually it means one thing: the downward slide economically continues unabated for the US, and hard times lay ahead.

The implications of the rating change are worth noting, but first some background is in order. The big credit rating agencies, like the S&P, have a scale which implies the level of creditworthiness for the particular item being rated.  Ratings could apply to a variety of things, from countries, to public and private corporations.  For the S&P, the ratings range from AAA (the highest rating possible) to D (the worst possible).  Along with those letter-based ratings, a qualifier can be attached to the rating, such as positive (an upgraded rating is likely), negative (a downgrade is likely), or neutral (a change in rating is uncertain).

When the S&P noted that US debt is now AAA negative, what it was actually saying is that within the next couple of years there is a reasonable likelihood (about a one-in-three chance) that the US credit rating will be downgraded from AAA to AA. 

The fact that it has come to this is sad.

Once the greatest economic power on the planet, we have now effectively had our credit score lowered due to the untenable financial situation we now find ourselves in.  If we are indeed downgraded to AA, our costs for borrowing money (interest rates) will rise in all categories.  Home loans, credit card interest rates, school loans, personal loans -- all of these modes of borrowing will become more costly to the borrower.

Why does this happen?  It happens because with a downgrade in credit rating comes a reduction in confidence by our lenders (namely, other countries) that we will be capable of making good on our interest and principal repayments.  Thus, they will charge us more for the money they lend us.  It is the price we must pay for showing the world we cannot effectively manage our own finances.

Think of it in terms of how individuals are dealt with when it comes to credit.  Person A has a very high credit score and displays a stable and healthy financial situation to his credit card company -- when he applies for a credit card, he receives a rate of say 8%.  Person B has a lower credit score and displays a less stable financial outlook -- when he applies for a credit card, he receives a rate of 12%.  Simply put, the credit card company is saying that they have more confidence Person A will repay his balance than Person B. 

One of the reasons cited for the S&P downgrade was the fact that it did not believe a political resolution to the US debt and deficit problems was achievable in the near term.  I agree wholeheartedly with this assertion.  The government had been squabbling over its 2011 budget several months past the point where it should have already had a budget in place, and the numbers they argued about ranged from the $30 to 100 billion mark.  

Problem is, the fiscal challenge that really matters, the one that S&P believes is outside the ability of our government to address, is in the $50 to 75 trillion range.  How can we have faith that the government will solve a $50 trillion problem when it can’t agree on a $100 billion problem?

We can’t.  There is no evidence that the political representation we have in place, on all sides of the aisles, in all political parties, has the collective will to come back to the American people and say:  “We promised you too much.  We can’t afford it.  We are reneging on our promises.”

Which party will step forward first and take away your Social Security?

Which party will step forward first and tell you that you no longer will receive Medicare?

So I believe that the S&P understands this dilemma that’s facing our government, and is reacting accordingly.  I strongly believe that within the next few years we will see a full downgrade to a AA rating, and perhaps even lower as the situation worsens.  

I think the main thing you can do for yourself, for you and your family’s finances, is to examine how much those finances are tied to the cost of borrowing.  In other words, what debts do you have and how quickly can you liquidate them to reduce your exposure to the worsening credit posture of the country you live in.   Obviously, the less you are reliant on credit, the better off you’ll be.  Of course, the problem here is that as our costs of living rise, and wage growth falls behind that curve, it will be necessary for more and more people to rely on credit in order to stay afloat.  It is this squeeze that will become the biggest concern for individuals and families over the next decade.