American government bonds are considered to be the world’s safest asset; no one expects the United States, the world’s largest economy, to default on debts. Yet, nearly two weeks away from a possible default, the world looks to be on the verge of a meltdown. There’s a similar situation brewing in Europe; rating agencies (private entities that ‘rate’ assets and stocks based on their safety, ability to repay investors and volatility) are downgrading some European countries on the fear that they may default on their debt.

The situation in America

As of now, the Republicans, who have a majority, are blocking all moves by the President to raise the debt ceiling (the amount the government can borrow). They are arguing that the government should cut down on spending instead of constantly borrowing more, which is fair. However, the Republicans are also refusing to raise taxes, and this makes it more a political problem than an economic one. Presidential elections are in a year, and a Republican majority agreeing to raise taxes would only hurt their chances, but at the same time by being strong on a debt reduction, they are showing that Obama can’t manage the economy. The solution is easier than its been made out to be, but the Republicans are playing hardball and maybe America might pay for a lack of foresight.

How the American government raises money

The government issues bonds (also known as treasury bills or t-bills), and the Federal Reserve (who are in charge of the money supply and interest rate) print money to buy these bonds. These bonds are also bought buy governments and private investors, and pay interest. This is known as open market operations to raise capital.

How does Europe come into this?

At a time when Euro-zone countries like Greece, Ireland and Portugal are having their bonds downgraded by rating agencies, and with Italy and Spain possibly being the next two to ask for loans, a fear could spread across global markets. Moody’s, a leading rating agency has threatened to downgrade America’s AAA credit rating (the highest possible) status if it defaults next month. Currently agencies have been downgrading in anticipation of a default, as a self-fulfilling prophecy, makes it harder for countries to borrow and so they are more likely to default. If the U.S. is downgraded, and so are other European countries, it could lead to a massive pull in investment across the world, as people will question what is safe, if the safest asset isn’t safe anymore. This could further lead to a contagion effect, where other countries are affected even if their economies are doing fine mainly because of global fear. A similar situation happened in 1997 — Asian Financial Crisis. However, a U.S. default is being called a technical default, since it would cut spending immediately or print more money.

Facts you should know

• The first time the U.S. defaulted was in 1979 when the Treasury couldn’t pay interests on $122 million worth of bonds.
• At approximately 98% of its total output (GDP), the government is running a national debt of $14 trillion.
• The debt is increasing by $40,000 per second and is the highest in 60 years.
• There would be a 44% immediate reduction in spending if the debt ceiling isn’t raised.
• If the government defaults, the result could lead to enormous investment losses.

If more European countries need austerity packages or bailouts and the U.S. defaults around the same time, the possibilities of chaos are endless and unknown.