On Friday night, Standard and Poor’s downgraded U.S. Government debt to AA+ from AAA. My initial reaction is “So what”?
This is just an opinion from a bunch of folks that have often been disastrously wrong in the past. They handed out AAA ratings like candy on Halloween for lousy mortgage-backed securities, and are thus one of the prime culprits for the financial meltdown (along with their competitors Moody’s and Fitch).
They had Enron rated AAA until just days before they wrote the eleventh chapter in their history. Not only that, but it is reported that they made a $2 trillion math mistake. In light of all that, perhaps a better name for the firm is “Poor Standards.”
Does this mean that U.S. interest rates are going to skyrocket? Probably not. They downgraded Japan a long time ago, and Japan has even lower long-term interest rates than we do.
A Political Decision
However, their reasoning in doing the downgrade has a bit of merit. S&P knows that as long as the federal debt is denominated in dollars (and last time I looked, we had not issued a lot of debt denominated in euros or yen or pesos), the only reason the U.S. could ever default is a political decision to do so. The government owns a printing press and can print all the dollars it wants. Those dollars can be used to pay off any amount of debt you can name.
Could this be inflationary? Of course, but that does not change the fact that they would still be dollars and would be a valid means of payment for the debt. While I think that Johnson & Johnson (JNJ) and Microsoft (MSFT) are fine companies, it is laughable to assert that they are better credit risks than the full faith and credit of the United States of America.
It is that political decision to do so that is the rub. A small faction of the Republican Party has managed to gain enough leverage to take the world economy hostage. Think that is overblown rhetoric? Well, it is the term Senate Minority Leader Mitch McConnell used:
“I think some of our members may have thought the default issue was a hostage you might take a chance at shooting,” he said. “Most of us didn’t think that. What we did learn is this — it’s a hostage that’s worth ransoming” (see here for full story).
The political system responded by paying the ransom in the form of the debt deal approved this week. Not passing it, and thus effectively making that political decision to default, would have been an unmitigated disaster.
Even if interest payments were prioritized and kept flowing, other vital spending would have been shut off. There would have been almost an overnight 10% drop in aggregate demand, and thus a 10% drop in GDP. Keep in mind that the entire real GDP drop in the Great Recession, even after the big downward revisions that came out with the second quarter GDP report, was just 5.1%.
Could It Happen Again?
So does the debt deal prevent another hostage situation? No, although we will not have to go through the debt ceiling circus again until after the election. It was set up as a two-stage deal. The first part was almost $1 Trillion in spending cuts. While those will slow the economy, fortunately the cuts are over the next decade, and are very back-end loaded.
Stage two is for a “Super Committee” to come up with a plan to reduce the deficit by an additional $1.5 trillion over the next decade, and they have to do so before Thanksgiving, and Congress has to approve the package by Christmas. If that does not happen, there will be $1.2 billion of spending cuts imposed, half in Defense and half non-defense, with a few key programs like Social Security and Medicaid exempted.
Those cuts will be a meat cleaver, not a scalpel, and will be both very front-end loaded and very damaging to the economy. While I think there is a huge amount of fat at the Pentagon that could be cut, and we could be much less involved as the world’s policeman, sudden meat-cleaver cuts are not the way to do it, and there could be a lot of very real damage to national security as well.
By slowing the economy (probably into another recession) tax revenues will fall sharply. Thus the $1.2 Trillion in cuts will not even succeed in doing much to bring down the deficit; it will succeed in throwing millions of people out of work.
It is abundantly clear that the GOP is going to appoint people to the committee who will never agree to any revenue increase, even the closing of the most egregious of tax loopholes (unless the closing of them is balanced off with cuts in tax rates to make them at most revenue neutral). The Democrats will probably appoint people who are dedicated to protecting programs like Social Security and Medicare.
History has shown that the Democrats are much more likely to cave than the GOP. At times it seems like Obama has been Capitulator in Chief as much as he has been Commander in Chief. However, even if the Democrats cave, it will not be until the last minute, so there will be lots of drama and uncertainty. Markets do not like uncertainty. Thus, if you enjoyed the debt-ceiling circus and are sorry that it is over, don’t worry — there will be an encore performance just before Thanksgiving.
AAA Not Our Biggest Problem
The problem is not that the U.S. does not have a AAA economy. The problem is that we are lacking a AAA political system. It is not that the U.S. can’t pay its debt, now or at any point in the long foreseeable future. It is that there is a significant risk that the U.S. will decide that it does not want to pay its debts.
Coming at a tumultuous time in the markets, this downgrading could cause some havoc in the markets on Monday and Tuesday. However, it is unlikely to change the underlying fundamentals that drive interest rates.
When markets get scared, the first place they are going to turn is still going to be into treasuries in a flight to safety, regardless of what S&P has to say about how safe they are. There is simply no other place to turn that is big enough to count.
AAA corporations are AAA because the companies don’t have a lot of debt. If institutions were to try to use, say, Swiss bonds to do what they have traditionally done with treasuries, they would have to buy so many francs that they would quickly drive that currency to levels that would flatten the Swiss economy.
The U.S. will never default, unless it goes crazy and decides to.
Zacks Investment Research
