The implications of a downgraded US

By Felix Salmon
April 18, 2011
Paul Krugman, looking at Japan, says that today's S&P news is "no big deal", based on the fact that Japanese long-term interest rates stayed low even after the country was downgraded in 2002.

" data-share-img="" data-share="twitter,facebook,linkedin,reddit,google" data-share-count="true">

Paul Krugman, looking at Japan, says that today’s S&P news is “no big deal”, based on the fact that Japanese long-term interest rates stayed low even after the country was downgraded in 2002. But of course if the fate of the US over the next 9 years is remotely similar to the fate of Japan over the past 9 years, that’s going to be a very big deal indeed — for the US economy, for its fiscal ratios, and for the entire world.

The potential global downside here is large, as Mohamed El-Erian explains:

The world looks to America for a range of “global public goods” — including the reserve currency, the deepest and most liquid government debt markets, and the “risk free” standard. With no other country able and willing to step into this role, the result would be global efficiency loses and a higher risk of economic and financial fragmentation.

That said, however, there is a silver lining if you look hard enough. “Efficiency”, after all, is a nice way of saying “fragility”. As a general rule, the more efficient something is, the easier it is to break. So if we want to move to a more robust world with fewer major crises, there will necessarily be a price to pay in terms of global efficiency loses.

A slow move away from the dollar’s reserve-currency status might not be such a bad thing, seeing as how that status has allowed the US twin deficits to grow to previously-unimaginable levels. Just as car traffic expands to fill the road space available, national debt ratios naturally tend to go up rather than down, unless and until some kind of external constraint is imposed by the markets and/or ratings agencies. In that sense, the news from S&P is simply a necessary part of how the US is going to get its fiscal act together.

US treasury bonds are always going to be the most liquid government debt market, simply by dint of their sheer size. As such, they will always be the benchmark off which all other debt is priced. It’s conceivable that one day a debt instrument somewhere will trade through treasuries. That’s fine — there’s no particular harm in that. Does it mean that US debt is not risk-free? Yes, that’s exactly what it means. But realistically no one has ever considered US debt to be risk-free: there has always, for instance, been the very real risk of inflation.

El-Erian is absolutely right to worry about where the world’s growth is going to come from as we move from a unipolar global market to something which looks more like a G-Zero world. But I suspect that transition is inevitable in any case, no matter what happens to the US credit rating or its national debt. And there’s precious little that the US or its legislators can do about it.

Comments
16 comments so far

“But of course if the fate of the US over the next 9 years is remotely similar to the fate of Japan over the past 9 years, that’s going to be a very big deal indeed.”

Felix, your implication here, appears to be that in the Japan story, deflation was brought about by downgrades in Japan’s credit, and hence, the US could be headed down that path? That cannot possibly be what you’re trying to say, or at least I hope that’s not what you’re trying to say.

Posted by GRRR | Report as abusive

Felix, the Japan and the US are not really comparable. Japan had (and still has) a high savings rate and preference for non-foreign goods; in the US it’s almost the opposite. For ten, twenty years or more US consumers have borrowed to buy foreign goods, US savings rates are low, personal and government debt levels too high, and the greed is still there, like an addiction.

Posted by FifthDecade | Report as abusive

Felix – a “slow” move away from the dollar as the primary reserve currency is likely to turn to a “fast and furious” move when you consider that global investors, much more than governments and central banks, will most likely drive this. The collapse of September/October 2008 should be a reminder that all our wishes for ‘orderly transitions’ in the financial/economic order are more wishful thinking than they are reality. At some point investor psychology is going to come massively into play, in a very disorderly manner. At least, that is the very real risk governments and institutions should be planning for.

Posted by NukerDoggie | Report as abusive

Indeed — I don’t think these moves are ever slow. When they head for the exit, everyone will head for the exit, fast.

Posted by MarshalN | Report as abusive

Comparing Japan with US?
You are comparing the highest net International Investment Position country against the lowest net International Investment Position country. Please also note that 94% of Japanese government bond (JGB) is held by Japanese, and, under severe deflation, Japanese banking system has always been struggling with rapidly increasing amount of deposit which they cannot find other ways to invest than JGB. Japanese are used to the world in which money increases its value over the time, and that’s why they always try to postpone spending.

I am not sure if US Treasury market functions the way Japanese government bond market functions.

Here is a research on Japan’s International Investment Position.
http://www.boj.or.jp/en/research/brp/ron _2010/data/ron1009a.pdf

Posted by equus | Report as abusive

isn’t S&P one of the can’t shoot right bunch that didn’t see that MBS were junk? if they can’t see that, how can we trust them to know when some thing is quite right? and a move to what currency? the Yen? no. Japan doesn’t want that and will fight it tooth and nail. the Euro? The Euro?? thats the same currency that Greece has right ??? The Yuan??? thinking they might want it, but wont do what is required to get it (be tradable. and allowed to appreciate and depreciate. that they won’t allow to ever happen. so that leave who???)

Posted by willid3 | Report as abusive

“And there’s precious little that the US or its legislators can do about it.” Well, I suppose the could exacerbate it in all kinds of ways, by, for example, defaulting on the national debt for short-term political gain. Or engaging in absurd levels of brinkmanship on the issue.

Posted by frit | Report as abusive

What will become of the Black-Scholes formula if the US Treasury gets an S&P downgrade?

Any use of the Black-Scholes formula requires a value for “r,” the risk-free rate of return. My understanding is that T-bills have provided a proxy for r.

What happens if they don’t anymore? If every instrument in the world is recognized as some risk, “r” will presumably remain in this and other formulas, but will have to be defined in some new manner.

Anybody have any idea (a) how that would be done and (b) how much of an upheaval, at least within the smallish world of financial mathematicians and modellers, this will create?

Posted by Christofurio | Report as abusive

Christofurio: Observe option prices, assume put-call parity, and back out r.

Posted by guanix | Report as abusive

> That said, however, there is a silver lining if you look hard enough. “Efficiency”, after all, is a nice way of saying “fragility”. As a general rule, the more efficient something is, the easier it is to break. So if we want to move to a more robust world with fewer major crises, there will necessarily be a price to pay in terms of global efficiency loses.

Insofar as “efficiency” and “fragility” are uncorrelated in the world we observe, it’s a selection effect; if something is inefficient, why wouldn’t we fix it? Perhaps because it’s more robust. If something is fragile, why wouldn’t we fix it? Perhaps because it’s efficient. In econospeak, we’re moving along a frontier.

The last sentence of your paragraph, then, seems quite likely — if we want more robustness, we have to give up some efficiency. Hence the sentence before that, as well. There is no silver lining, however, in exogenous efficiency losses that have no robustness benefits, and there is nowhere here where you actually argue that there are robustness benefits to the loss, in particular, of a global reserve currency.

The second sentence of the paragraph was presumably designed to appear as though it came from left field, and boy did it.

Posted by dWj | Report as abusive

Christofurio: More generally, all those parameters are kind of inferred from every derivatives price. Note that “implied volatility” is entirely derived from options prices (not vice versa). The major role of Black-Scholes is to provide some guidance toward interpolating the price of one derivative from the price of a bunch of other ones.

Posted by dWj | Report as abusive

Christofurio, The risk-free rate is important theoretically because it is the return of a hedged portfolio. However, it has never been an observable traded asset, and historically LIBOR has been a close proxy than treasuries (the treasury rate usually being farther below the risk-free rate than LIBOR is above.)

To actually execute a hedge on which arbitrage depends, one has to lend or borrow at market rates that are not risk-free. Thus, even if one could observe the risk-free rate, its use in a pricing formula would only be an approximation. Post 2008, one has to jump through all sorts of hoops to construct a discount curve, and maintain more of them (the price of a derivative in a collateralized portfolio being observably different from the price on a stand-alone uncollateralized basis.)

Treasuries are more important for commercial banking in the real economy, where they are used as lending collateral – commercial entities do not have access to insured deposits. As this collateral becomes riskier, the banking system becomes more fragile and susceptible to runs; exactly contra Felix’s theories.

Posted by Greycap | Report as abusive

“In that real world, interest rate normalisation would need only to reach 3.5% before 1 tax dollar in 3 would go to servicing that debt.”

That’s not precisely true, nb. The government is running a large primary deficit. Debt service flows directly to borrowing.

Time for the Treasury to issue eternal zero-coupon bonds. They would increase in value, according to a floating interest rate, but pay no interest and never mature.

Posted by TFF | Report as abusive

What a vague and misguided column. We’ll start with the vague:

“That said, however, there is a silver lining if you look hard enough. “Efficiency”, after all, is a nice way of saying “fragility”. As a general rule, the more efficient something is, the easier it is to break.”

What is that supposed to mean? Why would an efficient system be less robust than an inefficient one? Maybe I’m missing something, but I don’t even see how that would be true even on a physical level. But presumably you are assuming it is true physically, then extrapolating — on the basis of nothing — to say it must be true economically.

Which means WHAT? Got any EXAMPLES?

Does anyone?

If a system is efficient, it is likely to be widely adopted, and it must then be robust to withstand the heavy demand. That’s all I can think of, and it’s the opposite of your conclusion.

Now for the misguided: “national debt ratios naturally tend to go up rather than down, unless and until some kind of external constraint is imposed by the markets and/or ratings agencies.”

Really?? Congress has nothing to do with this “tendency” at all? I guess they must be like the 300-lb. man who eats 6,000 calories a day and blames his weight on hormones. Can’t help the “tendency.” That would mean the unthinkable — accepting responsibility.

Posted by NewsLady | Report as abusive

World’s stupidest opening paragraph:

“Paul Krugman, looking at Japan, says that today’s S&P news is “no big deal”, based on the fact that Japanese long-term interest rates stayed low even after the country was downgraded in 2002. But of course if the fate of the US over the next 9 years is remotely similar to the fate of Japan over the past 9 years, that’s going to be a very big deal indeed”

That’s like saying, “Paul Krugman says those raindrops we felt are no big deal, but if they turn into a gigantic hurricane then it is a big deal.”

Um, duh.

That drive who looked at you funny is no big deal. But if he goes insane and slams into you killing your whole family, then it is a big deal.

Talk about setting up straw men. Come on Felix, you’re smarter than this kind of Kudlow-worthy BS argument.

Posted by EconomistDuNord | Report as abusive

@EconomistduNord

You must have just got out of the wrong side of the bed this morning and it has followed you into the afternoon.

Felix pointed out the errors in Krugman’s suppositions, even to the point of suggesting a G-Zero paradigm shift in the world’s economic relationships.

For what it’s worth, I’d argue with the last sentence of the article which states that there isn’t anything that America ‘can’ do to alter that course. It would be more correct to state that there isn’t anything that America ‘will’ do.

I think there are actions that could be taken that would, in a decade or so, restore America’s position atop a unipolar world economy, but those actions would be drastic.

There is no reason for us to engage in those drastic measures because we already had six decades in that pinnacle position and during that time our system of government, law and finance failed miserably at keeping even our own house in order.

Posted by breezinthru | Report as abusive
Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/