Tuesday, July 26, 2011

The Debt Ceiling and Oil Prices: An Explanation

A friend wrote:

"can you please explain this to me?


There are a few different factors here, but to keep things simple I'll explain the primary one; if you'd like to know about others, just ask.

The main point here is that US debt is considered the least risky security in the world (it's frequently called a "risk-free" security, though that's a technical term for default risk, not a general term for actually having no risk. And, as we're seeing now, it's still possible for us to default).

Because US debt is the least risky security in the world, it's held by a LOT of people and organizations - banks and insurance companies use it to back their liabilities, corporations use it to store their extra cash, individuals who want something low risk use it for investment, China uses it to manipulate their currency prices to make Chinese investment/manufacturing grow, etc. In fact, there is so much US debt and US debt is so useful that there's actually a lot of demand for dollars from other currencies so that foreigners can buy US debt - Japan, Britain, China and other places hold vast quantities of debt, and that ignores all the foreign banks and insurance companies that use it.

If the US defaults or faces a downgrade in its credit rating (a measure of its risk) because the long term projected path of the deficit is too high, then a lot of the holders of that debt will either not want to hold US debt anymore, or will be contractually prohibited from holding it. The demand for US dollars to buy US debt would drop a lot, and less demand for US dollars means a weaker currency. A weak currency means our exports look cheaper to the rest of the world, so the rest of the world consumes more of our stuff, and imports get more expensive in dollars - it takes more dollars to buy them. We import a lot of oil, so a weaker dollar means that oil prices in dollars go up (it takes more dollars per unit of oil because the dollar is weaker). So betting on the prices of commodities that we import is a way of betting on a weaker dollar in the short term. (In the longer term, a lot more affects commodities prices than just the strength or weakness of the dollar).