"Because it's there." - English mountaineer George Mallory's response when questioned why
he wanted to climb Mount Everest. At
long last, the inevitable has come to pass.
Standard & Poor's, the rating agency, on
Monday affirmed the credit ratings of the US but
revised downward the country's outlook from stable
to negative. Essentially, the move makes it likely
if not altogether probable that the US will lose
its prized credit rating of triple-A over the next
two to three years. In the statement released
alongside the announcement, S&P commented:
"More than two years after the
beginning of the recent crisis, US policymakers
have still not agreed on how to reverse recent
fiscal deterioration or address longer-term
fiscal pressures," said Nikola Swann, the
primary S&P credit analyst for the decision.
"The outlook reflects our view of the increased
risk that the political negotiations over when
and how to address both the medium- and
long-term fiscal challenges will persist until
at least after national elections in 2012."
For many people including readers of
this column, the move by
S&P lacked any surprise
value as it has only been the truly dense who
really believed that the US government deserved
its triple-A credit rating since the onset of
Keynesian policies in 2008; to be fair also, the
intensely dumb tax cuts promulgated by the George
W Bush administration before the crisis fatally
weakened the US fiscal position in the last five
years of the country's bubble era.
So what
is the big deal with the possible downgrade of the
US government for the investment community? There
is a very long thesis in here somewhere about the
role of a benchmark and what it does for the world
of asset pricing, but quite simply all arguments
about the US government bond goes to the little
equation that lies at the heart of the Capital
Asset Pricing Model (CAPM).
In simple
terms, the notion is that if investors can earn
some return for effectively "doing nothing", the
return they would demand for "doing something"
would have to be proportionately higher to
compensate for the extra risk involved. For much
of the past 50 years, the idea of "some return for
doing nothing" was defined to be the yield of the
US government bond.
There was however an
implicit assumption - that the US government would
always be able to issue any amount of new debt to
pay for its maturing debt, or else have other
assets that it could sell in order to pay for the
same. This is what a "triple-A" rating means -
there is NO risk of losing one's capital. The
S&P move, though, casts doubt on exactly this
article of faith commonly held around the world. A
downgrade from triple-A doesn't mean that the US
government would default on its debt imminently
(or indeed, at all) but it does mean that a
prudent long-term investor can no longer make the
assumption that this is the case.
Readers
should note here that the S&P move on the US
government is not the same as the recent actions
on various European sovereigns. Downgrading likes
of Spain, Portugal and Ireland is different
because these countries cannot print their own
currency (the euro), thereby making their
government bond issues akin to debt issued in a
foreign currency. Therefore, their downgrades are
similar to those that plagued various "emerging"
economies which issued their debt in US dollars to
attract a global investor base.
The US in
contrast issues debt only in US dollars, and
therefore theoretically has unlimited ability to
issue currency that can be used to pay off debt
that matures. Only one other country in recent
history has had the luxury of issuing its debt
purely in its own currency but still suffered the
indignity of seeing its credit ratings downgraded:
Japan. We all know how that story panned out - if
not, please feel free to view the charts for
Japanese stocks and bonds for the past 10 years.
What the gurus say ... and don't
Coming on the same day as global
conniptions from the European periphery, where a
restructuring of Greek sovereign debt was being
widely mooted and even welcomed by certain German
politicians, the action by S&P on the US
sovereign rating was bound to attract wide
attention. The news prompted an already jittery
market to sell off almost 2% before a dead-cat
bounce brought back losses to just over 1% for the
day. Other indicators of risk appetite such as
credit spreads also widened for the day; while
that old safeguard gold saw its prices rise
further.
Predictably, the gurus chimed in.
Mohammad El-Erian, the peripatetic co-chief
investment officer and chief executive officer of
the giant bond investment manager PIMCO commented
on the S&P action in the Financial Times
almost immediately after the S&P action:
The continued failure to come up
with a credible medium-term fiscal reform
program would increase borrowing costs for all
segments of US society, thereby undermining
investment, employment and growth. It would also
curtail foreigners' appetite to add to their
already substantial holdings of US assets. And
it would weaken the dollar.
The US also
risks eroding its standing at the core of the
global monetary system.
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 losses and a higher
risk of economic and financial
fragmentation.
Then again, his co-CIO
is the redoubtable Bill Gross, who wrote in
PIMCO's Investment Outlook for April 2011, which I
referred to in a previous article in Asia Times
Online, that his firm had been...
"... selling Treasuries because they
have little value within the context of a $75
trillion total debt burden. Unless entitlements
are substantially reformed, I am confident that
this country will default on its debt; not in
conventional ways..."
In the context
of the statement by Gross, el-Erian suddenly
appears to be the cheerleader for PIMCO rather
than a disinterested commentator. In a situation
like this, the more important question appears to
be really one of what the gurus do not wish to
comment upon rather than what they do comment.
Specifically, the question gnawing at the
core of the market is the one about who exactly is
affected by any S&P downgrade of the US
sovereign. Is it China, with its $1 trillion of US
government bonds? Of course, that is indeed one
victim and one that I have long commented upon in
this column. The symbiotic relationship between
China and the US - supplier and borrower - has
been long documented by other authors.
This is however, not the whole story. The
biggest buyer of US government bonds over the past
two years hasn't been China or any Middle-Eastern
nation, but rather the US Federal Reserve. Yes,
the same agency which is the repository of all
currency printing activities in the US.
A
number of commentators point out that this
relationship is similar to the quantitative easing
efforts of the Bank of Japan, the European Central
Bank (in relation to debt issued of peripheral
European governments) and the Bank of England.
That however misses a key point of distinction -
the US Federal Reserve is not a public institution
but rather a privately owned corporation. It is
owned by chartered banks across the US.
This leads to an interesting circularity -
the US government issues debt that is purchased by
the US Federal Reserve, which is owned by a group
of US commercial banks; some of these banks got
into a boatload of trouble in 2008 and were
rescued by (drum rolls please) the US government.
In part, the federal spending on the bank rescues
(including efforts to stabilize the housing market
and hide the weaknesses embedded in US mortgage
securities) goes to the heart of the US
government's excessive issuance of debt -
precisely what S&P expressed its concerns
about.
A cynic would take a step back from
that circularity and merely prescribe that S&P
highlighted its own role in continuing the
charade: namely that the easiest way to keep the
circularity intact is for the US government to
retain its triple-A ratings. A rating agency that
is being viciously attacked by US government
officials may just be striking a point about its
own survival rather than make any grandstanding
remarks about the credit worthiness of the US
government.
Put in that harsh light of
agency survival, the rating action merits no more
than a footnote in the dire history of the
financial crisis. The real action that would help
to reverse the flow of the past few years by
shrinking bank balance sheets, hitting asset
valuations and embedding a sustainable basis for
the global economy to grow - ah, but that work is
yet stillborn.
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