U.S. debt downgrade: Who cares?
By Laurence Copeland. The opinions expressed are his own.
As I write this blog, it looks as though the U.S. Congress is going to pass a bill raising the debt ceiling and making modest cuts in Federal Government spending over the coming years. Although it is, quite rightly, being presented as a somewhat hollow victory for the forces of reason, there is one extremely puzzling aspect of the crisis.
It is being reported on all sides that the credit rating agencies may well downgrade U.S. sovereign debt in spite of this “happy ending” – indeed, Egan-Jones, one of the smaller agencies, cut its rating of U.S. debt some weeks ago, and there is much talk of Moody’s and S&P following suit in the very near future.
This is all rather puzzling. After all, a credit rating is an assessment of how reliably lenders can count on the borrowers repaying their dollar loans (principal plus interest) in full and on time. Now the only scenario I can imagine in which the U.S. Treasury fails to meet its legal obligations to its creditors is one in which the Congress blocks a rise in the debt ceiling explicitly so as to bring about a default – and even then it would presumably require the collaboration of the executive because, as many people have pointed out in the current cliffhanger, even if further borrowing is impossible, U.S. tax revenues are far greater than the cost of servicing the debt.
In other words, the Administration can always pay its legal debts – it is only about to run out of money on August 2nd, in the sense that tax revenues are insufficient to cover legally required payments to Uncle Sam’s creditors plus hundreds of billions of dollars of other commitments which the federal Government is politically (and no doubt to a great extent morally), but not legally bound to pay, such as: social security payments, purchases (unless already ordered), wages to civil servants without contract, and so on and so forth. It can delay most of those payments without contravening criminal or civil law, and in most cases can walk away from its commitments altogether with no legal penalty, though of course the outcome might be politically or socially explosive.
In short, whichever way you tell the story, as far as I can tell, default by the USA (or indeed by Britain) could only occur as a result of a conscious political decision to do just that. By contrast, all the forecasts are that Greece will have no choice in the matter. The distinction, as I have pointed out before, is that while Greece’s debts are in a “foreign” currency – it has no right to print euros – the Fed or Bank of England can print as many dollars or pounds as it takes to repay their debts. In the process, of course, the domestic and foreign purchasing power of their currencies will be devastated, but they will have discharged their legal debts. As far as America is concerned, with the exception of a relatively small quantity of so-called TIPS (Treasury Inflation Protected Securities), U.S. bondholders have what economists call a purely nominal claim i.e. one that is denominated in current dollars, not dollars of constant purchasing power. By lending to the USA, they have given a hostage to fortune, a risk which, if they were wise, ought to have been reflected in the yield they demanded before buying the bonds in the first place.
All of which does nothing to resolve the original puzzle, because however dishonest, disreputable or unethical one may think is this scenario, “backdoor default”, as Mark Calabria of the Cato Institute has called it, does not qualify as a default in the sense relevant to the a country’s credit rating, nor (I assume) does it count as a credit event for the purposes of credit default swaps, the main instrument for insuring investors against default by bond issuers.
There is no need to rely on hypotheticals here. On the 15th of this month, it will be the fortieth anniversary of the day President Nixon was forced to close the gold window, as it was called, effectively taking the USA off the gold standard and starting the era of floating exchange rates. The end of gold convertibility was an unavoidable result of the previous U.S. Administration’s simultaneous expansion of welfare at home and military spending in Vietnam, both of which were financed by printing money (does any of this sound familiar?).
The left hand graph below shows what has happened to the dollar in those forty years. It is now worth less against more or less every single currency. Most spectacularly, it has lost three quarters of its value against the Yen and nearly 80 percent against the Swiss franc, over a half against the Singapore dollar, and it had lost nearly as much against the deutschemark before the birth of the euro in 1999. Predictably, the only major currency which has lost against the dollar (apart from the Hong Kong dollar, which has been effectively fixed for the last 25 years) is the pound, which is worth only half as much as in 1972.
Nor has the rot stopped since the global financial crisis started. As can be seen on the right, since Sept 2008 (“Lehman Day”), Britain has yet again managed to drive the Pound down against the dollar (quantitative easing at work), but every other currency has appreciated – the Swiss franc and the yen by a staggering 30 percent. Even the euro, for all its many problems, has held its own against the dollar.
Three points are worth making about this depressing history.
First, there is a consistent downward trend to the exchange rate history of both Britain and the USA, yet both have had untroubled AAA credit ratings ever since World War II, so it is hard to see any reason for a downgrade now. Sure, they are going to repay their lenders in devalued currency – as the graphs show, they have been doing so for four decades now – what’s new? This is how Britain paid for two world wars, and unfortunately it shows little sign of breaking the habit now.
As far as the USA is concerned, it had burned its way through its mountain of assets a decade ago and has been piling up debts ever since, exploiting (and, in the process, squandering) its privilege of seigniorage. Again, what has changed? Are the credit rating agencies redefining their ratings by stealth? I am mystified.
Secondly, the shenanigans of the last few weeks in Congress and the stance taken by Republicans more or less guarantee the continued long run decline of the dollar, for the simple reason that, like the classic Latin American banana republic, the harder it is for the USA to raise explicit taxes, the more likely that current or future administrations will resort to the inflation tax to finance their expenditures. I certainly find it impossible to imagine the U.S. returning to fiscal stability by spending cuts alone, as the Republicans insist it must – though I would love to be proven wrong.
Finally, can someone explain to me why investors all round the world still seem to regard the dollar as a safe haven? Why do they run to U.S. Treasuries every time the markets are nervous? Of course, everything has a price – but 30-year US Treasuries at 4 percent?
Never mind the credit rating, AAA or BBB, you’ll get your dollars on the nail – but what will they be worth when you get them? I know Henry Ford said “History is bunk” – but I reckon history shows he was wrong.
Image — U.S. Representative Peter DeFazio (D-OR) holds his notes as he talks to reporters after a Democratic caucus meeting about debt relief legislation with U.S. Vice President Joe Biden at the U.S. Capitol in Washington August 1, 2011. REUTERS/Jonathan Ernst