Making sense of the US Debt

The media has been rampant about the S&P downgrade of US credit rating. The speculations from the economists tout the end of the world for the richest nation and the beginning of a new world order. But before we jump to conclusions, I think we must try to understand how it all came about. This shall help us understand the issue and take an informed decision.

Imagine there are two countries - East and West. At the start of time, both nations are identical in terms of resources. People produce same goods and are completely self sufficient. There is no trade happening.

In due course, East citizens increase their production levels - either through better technology or just plain working for more hours. This helped them produce surplus goods that they can't consume. So they approach the West with a proposition.

"You guys buy our surplus goods and have more time to enjoy life than slog in the fields."

West readily accepts this and their citizens now have lots of free time. They would get their requirements imported from East and pay for them in Westro (Western currency/bonds). Over the next decade, East accumulates large amount of Westro and began to feel nervous if West would be able to ever pay them back. After all, Westros are nothing but claims against future production of West which already is declining.

So East citizens try out a different scheme.

They trade back the Westros for fixed assets in West.

This saves the East from the risk of holding a paper that has no value if West decides to dishonor its committments. The fixed assets would still  retain their value.

Now, West realises the problem -

They not only have to work to service their outsanding Westros but also need to pay rent for the fixed assets that are now owned by East. 

In a nutshell, they have practically sold their country to East without a bullet getting fired.

What do you think can West now do to bail them out? If you can find the answer, you pretty much hold tomorrow's newspaper in your hands.

Inspired from Berkshire Hathway 2010 Annual Report