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Bad outlook.
Apr. 19th, 2011 02:59 pmSo, how significant was Standard & Poor's decision to downgrade its outlook on US debt to negative from stable? From one point of view, very significant, and from another point of view (even if both parties do not disagree on the underlying reality) not significant at all.
How so? Well, let's take the "very significant" side of the argument. Despite Moody's posturings earlier in the year, and despite general mutterings throughout the economic ethersphere, this was the first "official" act by an influential corporation that said, quite clearly, that the AAA rating of US debt was under threat. It's one thing for everyone to be talking about how unsustainable is the current US deficit, but it's another thing entirely for one of the leading rating agencies to say so. It's now there, in black and white. T-Bills are not "risk-free". When companies say that their cash is in "risk-free" funds, they will have to note that US sovereign debt is on credit-watch negative. That implies a 33% chance of a downgrade within two years.
But the markets did not react as if the sky was falling. There was a fairly immediate sell-off of stocks and bonds in the US. Gold went up by a few bob (nearly 2%), and the dollar fell back a bit vs the yen. But today it became clear that the sky had not fallen in. For why? Because, as the "not significant at all" arguers have said, S&P has said nothing that wasn't already known by everyone in the market. I dare say that it might have come as a shock to Tim Geithner and others on Capitol Hill, but pessimism about US debt is nothing new. And, in the markets, just because people finally decide to call a spade a spade, that has little effect if the implement in question was being used as a spade for the previous nine months. No-one will say "OMG it's a spade! What shall we do?" Or, if they do, the only answer is "carry on using it as a spade".
And that's kind of what happened. And here we move away from American sovereign debt, and have to start looking at global sovereign debt. As I wrote, with some tedious repetition, back when Ireland seemed to believe that it could "guarantee" the debt of its banks, the "solution" to the 2008 crisis was no solution at all. It just transferred the problem to sovereign debt. (By way of an aside, at that time S&P put UK sovereign debt on creditwatch negative, only to withdraw the outlook 18 months later.) At that time the myth was maintained that it was a problem of liquidity rather than solvency. But now S&P has effectively told Capitol Hill (not the markets, which knew already) that it's no use putting off the structural deficit until after the next election. Either something is done by the politicians before then, or there will be a downgrade.
So, let's shoot ahead 18 months. Let's assume that the US can't get its act together and will continue what appears to me to be an insane subsidy of the American middle classes through Medicare and social security benefits. (As with many of the concessions in the UK, its those benefits enjoyed mainly by the comfortable middle class that are defended most vociferously. Note how quiet the Tea Party has been on the US mortgage subsidy programme - which was of disproportionate benefit to the middle classes in the US.)
Because the US fails to get its act together, S&P downgrades US sovereign debt to AA+. What are the implications? Well, in theory they are enormous. This is because of the capital requirements imposed on financial institutions and the onerous effect it would have if, suddenly, these institutions had to admit that some of their investments weren't actually in the safest of the safe, but were in a bit of a banana-boat junk economy that had only been kept afloat by the fact that the US dollar was the world's reserve currency.
When the UK had a currency that became the world's reserve currency, we used much of the wealth to improve Britain's infrastructure. The Americans used it to create a credit bubble.
So, the US is at AA+. Do all of the US financial institutions suddenly have to pull out of T-Bills and invest in something else? Well, obviously not. The world's regulatory structure rests on two fundamentally incorrect assumptions. The first is that there is such a thing as absolute value, and the second is that there is such a thing as guaranteed liquidity. This is because, for the last 60 years, the regulators could say "if in doubt, there's always US Treasury Bills". That, as it were, was the base parameter. They were 100% safe and you could always sell them at market value if you had to.
But once the base parameter is taken away, the entire regulatory edifice falls. Either you find a new base parameter, or you change the rules. And what would happen is that the accounting rules would change.
So, when looked at this way, a change in the rating of the US dollar doesn't matter a toss. All that matters is whether or not the US actually defaults. I'm always one for "never say never", but I don't see that happening in the next decade.
Indeed, in the long term, I'm one of those rare dollar bulls. Because, unlike the UK or Japan, America is fucking big and it produces a hell of a lot of food. And, when push comes to shove, fundamental value is having enough to eat, somewhere to live, and a skilled workforce.
As I said, this is also not just a matter of US sovereign debt and US profligacy. We are currently in a situation where the two major fungible currencies -- the dollar and the euro -- are as horrible as each other. And in China, where the Yuan remains fairly rigidly controlled, artificially low interest rates have created a property bubble.
The current dollar situation (as opposed to the long-term view for the dollar) is interesting. Countries such as China were generating so much wealth that they had to put it somewhere. So they bought dollars. The US obligingly printed those dollars. But now we have got to the situation where China has SO MANY dollars, and the US has such a resistant fundamental deficit, that China has to buy more dollars to maintain the value of the dollars that it has already got. Or, rather, it has to buy more dollars to maintain the myth that the dollars it already has are worth what it says they are worth.
There are two obvious parallels to this. The first is that China is a bit like a victim of a 419 scam. It spends more and more because it doesn't want to stand up from the table and have to write down as a loss the money it has already spent (in Q4 China's foreign currency reserves rose to $2.85trn, up by $199bn in a single quarter - http://bloom.bg/gNFHiR). This phenomenon, the "dollar trap", is well known. See for example here: http://www.nytimes.com/2009/04/03/opinion/03krugman.html?_r=2
The second parallel that occurs to me is the last months of the Maxwell Empire in 1991, when Robert Maxwell was the only buyer in town for MMC shares. He had to do this because they were used as collateral on his loans. It was the maintenance of MMC's share price that led Maxwell to raid the Mirror pension fund.
So, it basically boils down to "what will China do?" Will it carry on deceiving itself a la Maxwell or the victim of a 419 scam, buying more and more dollars in order to maintain the value of the dollars it already has? If it does this, there is little incentive for the US to clean up its act.
Or will China accept that it has made a bad bet, and slow down or even halt its US dollar purchases? With about $2trn in dollars in the Bank, a 50% dollar collapse would wipe out all of China's current account surplus in the past five years. In other words, it would all have been for nothing.
But this might, for China, be a price worth paying. In the grand scheme of things, five years is nothing. Even if such a move devastated US imports, China would probably get it all back in another five years or so. The other plus would be that the US would be forced, absolutely forced, to get its act together. This would not be a return to the 1930s. But it would entail a fall in living standards, and one which would hit the middle classes the most. It would also be just about the best way we have to get the world economy back into some sort of balance. However, what it most certainly would not be would be painless.
The great unknown, then, is not economic, but political. What precisely would the political impact of this be?
And there, I admit, I have to utter the immortal line of John Maynard Keynes. "Fucked if I know".
_____________
How so? Well, let's take the "very significant" side of the argument. Despite Moody's posturings earlier in the year, and despite general mutterings throughout the economic ethersphere, this was the first "official" act by an influential corporation that said, quite clearly, that the AAA rating of US debt was under threat. It's one thing for everyone to be talking about how unsustainable is the current US deficit, but it's another thing entirely for one of the leading rating agencies to say so. It's now there, in black and white. T-Bills are not "risk-free". When companies say that their cash is in "risk-free" funds, they will have to note that US sovereign debt is on credit-watch negative. That implies a 33% chance of a downgrade within two years.
But the markets did not react as if the sky was falling. There was a fairly immediate sell-off of stocks and bonds in the US. Gold went up by a few bob (nearly 2%), and the dollar fell back a bit vs the yen. But today it became clear that the sky had not fallen in. For why? Because, as the "not significant at all" arguers have said, S&P has said nothing that wasn't already known by everyone in the market. I dare say that it might have come as a shock to Tim Geithner and others on Capitol Hill, but pessimism about US debt is nothing new. And, in the markets, just because people finally decide to call a spade a spade, that has little effect if the implement in question was being used as a spade for the previous nine months. No-one will say "OMG it's a spade! What shall we do?" Or, if they do, the only answer is "carry on using it as a spade".
And that's kind of what happened. And here we move away from American sovereign debt, and have to start looking at global sovereign debt. As I wrote, with some tedious repetition, back when Ireland seemed to believe that it could "guarantee" the debt of its banks, the "solution" to the 2008 crisis was no solution at all. It just transferred the problem to sovereign debt. (By way of an aside, at that time S&P put UK sovereign debt on creditwatch negative, only to withdraw the outlook 18 months later.) At that time the myth was maintained that it was a problem of liquidity rather than solvency. But now S&P has effectively told Capitol Hill (not the markets, which knew already) that it's no use putting off the structural deficit until after the next election. Either something is done by the politicians before then, or there will be a downgrade.
So, let's shoot ahead 18 months. Let's assume that the US can't get its act together and will continue what appears to me to be an insane subsidy of the American middle classes through Medicare and social security benefits. (As with many of the concessions in the UK, its those benefits enjoyed mainly by the comfortable middle class that are defended most vociferously. Note how quiet the Tea Party has been on the US mortgage subsidy programme - which was of disproportionate benefit to the middle classes in the US.)
Because the US fails to get its act together, S&P downgrades US sovereign debt to AA+. What are the implications? Well, in theory they are enormous. This is because of the capital requirements imposed on financial institutions and the onerous effect it would have if, suddenly, these institutions had to admit that some of their investments weren't actually in the safest of the safe, but were in a bit of a banana-boat junk economy that had only been kept afloat by the fact that the US dollar was the world's reserve currency.
When the UK had a currency that became the world's reserve currency, we used much of the wealth to improve Britain's infrastructure. The Americans used it to create a credit bubble.
So, the US is at AA+. Do all of the US financial institutions suddenly have to pull out of T-Bills and invest in something else? Well, obviously not. The world's regulatory structure rests on two fundamentally incorrect assumptions. The first is that there is such a thing as absolute value, and the second is that there is such a thing as guaranteed liquidity. This is because, for the last 60 years, the regulators could say "if in doubt, there's always US Treasury Bills". That, as it were, was the base parameter. They were 100% safe and you could always sell them at market value if you had to.
But once the base parameter is taken away, the entire regulatory edifice falls. Either you find a new base parameter, or you change the rules. And what would happen is that the accounting rules would change.
So, when looked at this way, a change in the rating of the US dollar doesn't matter a toss. All that matters is whether or not the US actually defaults. I'm always one for "never say never", but I don't see that happening in the next decade.
Indeed, in the long term, I'm one of those rare dollar bulls. Because, unlike the UK or Japan, America is fucking big and it produces a hell of a lot of food. And, when push comes to shove, fundamental value is having enough to eat, somewhere to live, and a skilled workforce.
As I said, this is also not just a matter of US sovereign debt and US profligacy. We are currently in a situation where the two major fungible currencies -- the dollar and the euro -- are as horrible as each other. And in China, where the Yuan remains fairly rigidly controlled, artificially low interest rates have created a property bubble.
The current dollar situation (as opposed to the long-term view for the dollar) is interesting. Countries such as China were generating so much wealth that they had to put it somewhere. So they bought dollars. The US obligingly printed those dollars. But now we have got to the situation where China has SO MANY dollars, and the US has such a resistant fundamental deficit, that China has to buy more dollars to maintain the value of the dollars that it has already got. Or, rather, it has to buy more dollars to maintain the myth that the dollars it already has are worth what it says they are worth.
There are two obvious parallels to this. The first is that China is a bit like a victim of a 419 scam. It spends more and more because it doesn't want to stand up from the table and have to write down as a loss the money it has already spent (in Q4 China's foreign currency reserves rose to $2.85trn, up by $199bn in a single quarter - http://bloom.bg/gNFHiR). This phenomenon, the "dollar trap", is well known. See for example here: http://www.nytimes.com/2009/04/03/opinion/03krugman.html?_r=2
The second parallel that occurs to me is the last months of the Maxwell Empire in 1991, when Robert Maxwell was the only buyer in town for MMC shares. He had to do this because they were used as collateral on his loans. It was the maintenance of MMC's share price that led Maxwell to raid the Mirror pension fund.
So, it basically boils down to "what will China do?" Will it carry on deceiving itself a la Maxwell or the victim of a 419 scam, buying more and more dollars in order to maintain the value of the dollars it already has? If it does this, there is little incentive for the US to clean up its act.
Or will China accept that it has made a bad bet, and slow down or even halt its US dollar purchases? With about $2trn in dollars in the Bank, a 50% dollar collapse would wipe out all of China's current account surplus in the past five years. In other words, it would all have been for nothing.
But this might, for China, be a price worth paying. In the grand scheme of things, five years is nothing. Even if such a move devastated US imports, China would probably get it all back in another five years or so. The other plus would be that the US would be forced, absolutely forced, to get its act together. This would not be a return to the 1930s. But it would entail a fall in living standards, and one which would hit the middle classes the most. It would also be just about the best way we have to get the world economy back into some sort of balance. However, what it most certainly would not be would be painless.
The great unknown, then, is not economic, but political. What precisely would the political impact of this be?
And there, I admit, I have to utter the immortal line of John Maynard Keynes. "Fucked if I know".
_____________
