September 14 2011
by Todd Hixon

What the Downgrade Means for Entrepreneurs: Part 1, What’s Happening

A downgrade of the U.S. sovereign credit rating has never happened before, so it’s worth examining what it means for entrepreneurs.  This is the first of three posts, focused on what’s happening.  Part 2 will look at the impact on entrepreneurs and the venture market, and Part 3 will suggest how entrepreneurs can survive and prosper.

The severe stock market reaction shows that the downgrade is a big event:  the Dow sold off 5% the day following the downgrade, and bounced back 4% the next day when the Fed made an unprecedented commitment to two more years of near-zero short-term rates.  The Dow sold off 15% during the countdown to default, and since then we’ve seen high volatility with no net appreciation.

Slippery Slope With Hard Landing: DJIA from July 22 to September 13, 2011

What’s happening? First, it’s not September 2008 redux.  2008 was a financial crisis: the financial sector bet the farm on highly leveraged investments backed by residential real estate [“safe as houses”], and when the value of housing duly collapsed, no one knew who was under water. Banks and companies could not borrow because investors did not know who would survive. Governments became the lenders of last resort, and the U.S. Treasury was the rock in the storm. All the over-borrowed parts of the economy (consumers, banks, government) have been forced to cut spending, which caused a strong recession with a slow recovery, and a big reduction of appetite for all risky investments, including venture capital.  [Lousy VC returns since 2000 are a big factor here, too.]

The downgrade is a political crisis, much as S&P said.  For a century the U.S., Europe, and Japan have built a welfare state financed heavily with debt: explicit debt and under-funded benefit schemes.  The U.S. added massive government-guaranteed housing finance (Fannie & Freddie).  These programs produced benefits and safety nets for middle class citizen and middle class jobs, especially construction jobs.

The “western” welfare state is now reaching “physical” limits created by demography, debt capacity, and burgeoning health costs, like microprocessor clock speeds hit physical limits. The demographic problem is the aging of the population (heading below 2 workers per retiree), which makes retiree benefits paid by current workers unbearably expensive. The inefficient U.S. health care system adds a huge stone to the load.

The debt capacity limit is self-evident:  when sovereign debt hits 100%-150% of GDP, investors demand more interest, or walk away. The financial crisis propelled governments towards this limit when it forced them to borrow extravagantly to bail out key institutions and prop up demand. The U.S. has special advantages (sort of “too big to fail” on a global scale) but is not fundamentally immune. The downgrade is a warning that the U.S. is reaching its limit and has no strategy to turn back.

Western governments struggle to respond.  Benefits must be reduced; health care spending must be streamlined and somehow limited; and taxes must increase.  Greece, France, and Britain have had riots.  The U.S. has gridlock leading to brinksmanship with default. We rail at our leaders for slow progress, but, realistically, they’re cleaning up a mess made by four generations of politicians.

The political crisis creates huge economic uncertainty.  The fate of large economies, interest rates, tax rates, and the structure of government spending will see major change that is hard to forecast. The crisis will rumble on for years, with acute problems (e.g., an Italian debt crisis) breaking out sporadically.

In my next posts:  what this means for entrepreneurs, and what action entrepreneurs can take.

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