S&P U.S. warning — late and welcome

April 19, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

Standard & Poor’s decision to put the U.S. on warning that it may lose its AAA debt rating is both deliciously absurd and genuinely earthshaking.

Absurd because S&P are some of the people who missed the real estate bubble and mortgage bond implosion; and earthshaking because not only has the U.S. never held less than a AAA rating, much less been put on threat of downgrade, it thoroughly deserves the warning.

Standard & Poor’s cited the risks of a lack of a credible plan to reduce the national debt and said the move flags a one-in-three chance of a downgrade over the coming two years.

The ratings agency said there was a material risk policymakers won’t come to a meaningful and plausible budget agreement by the 2012 elections, leaving the U.S. weaker than its AAA-rated peers.

Beyond the risk of a lack of political will to tame the budget, S&P also raised the fiscal threats coming from the financial sector, which it now puts as higher than before 2008. So much for financial reform, then. Net external debt, a measure of U.S. dependence on foreign creditors, is now at 300 percent of current account receipts, among the highest of any sovereign, much less those that consider a AAA rating to be something akin to a birthright.

What is both said and not said in S&P’s analysis is the fact that it is only the U.S.’s exorbitant privilege as the main global reserve currency that even allows it to have strayed this far without already being downgraded. If Canada was in an analogous position to the U.S. it would have long ago been kicked out of the AAA lounge, in much the same way that if I behaved like Charlie Sheen I would be homeless.

This is perhaps why the threatened downgrade is so hard to digest; the U.S. and its supposedly risk-free Treasuries are at the heart of all global finance, and a system in which people will have to find alternatives, both as investments and yardsticks, is difficult to imagine.

That something is difficult to imagine, however, does not mean that it won’t come to pass, only that if it only partly comes to pass the impact will be big. Firstly, if the U.S. loses its AAA rating it could prove to be the turning point in a loss of confidence that starts a debilitating move out of not only Treasuries but dollar assets. After all, the U.S. won’t default on debts which it can erase with the flick of the switch on the printing press, but it may well inflate its way to making dollar holdings very bad investments.

Secondly, the lack of alternatives means that a move out of Treasuries, if it ever came, would be hugely distorting for the rest of the world’s debt ecosystem. There simply aren’t enough “safe” alternatives.

QUESTIONABLE AUTHORITY

One argument advanced for why we shouldn’t care about the threatened downgrade is S&P’s (and other ratings agencies’) track record of being spectacularly wrong, first in various emerging market sovereign crises and then during the housing bubble.

I’d argue the opposite; ratings agencies have a reputation of being timid and late, and are also beholden to government-granted status as Nationally Recognized Statistical Ratings Organizations for much of their business. That one of them steps up and threatens the U.S.’s rating is a sign that cannot be ignored.

There is also the argument, notably espoused by Richard Koo of Nomura Securities, that ratings agencies have failed to understand the role of public debt during a balance sheet recession, one characterized by mass paying down of debt by the household and business sectors at the same time.

Koo argues that this paying down of debt by definition makes cash available to finance public debt and spending, which are needed lest the economy, like Japan’s, languish.

I worry that this assumption — that the savings raised during deleveraging makes a government financing crisis unlikely — worked better for Japan than it will for the U.S. While neither economy is closed, U.S. investors are a whole lot more likely to sell out of Treasuries than were the Japanese of the past 15 years. This is even before we come to the high U.S. reliance on foreign financing.

The best, and perhaps the most likely, outcome is that the U.S. enjoys a long, slow slide from being everyone’s favorite debt issuer and owner of the main reserve currency to something a whole lot less. After all, being free to borrow cheaply and almost without limit has hardly been an unalloyed blessing. This implies losing the AAA-rating, but maybe only for long enough to teach itself and the rest of the world not to be so dependent upon it.

The transition from a unipolar financial world to something with more checks and balances will be painful, but in the end beneficial.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

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