Yes, I know I dissed the S&P report as fundamentally wrongheaded, but as we will discuss shortly, it contained some interesting commentary on the US financial sector that has gotten perilously little notice.
But I’d first like to address the way the media and some blogosphere commentators have hopelessly muddied the issues on the downgrade scaremongering. One is the “we depend on foreigners to fund our budget deficit” hogwash. As Michael Pettis pointed out, the idea that the US is funding its federal deficit from foreigners is a widespread misconstruction. The reason we have capital inflows, largely but not entirely foreign purchases of Treasuries, is that we are running a current account deficit. As long as our trade partners want to run surpluses with us, they wind up holding dollars. They could just keep them as cash, but most seem to prefer to get some income, and Treasuries are a popular choice because they are liquid.
If they want to quit accumulating dollars, they have to stop running surpluses with us. Despite all the brave talk of rebalancing, no one seems very keen to do that right now. Most countries except the US seem to like the idea of having high domestic employment rates by virtue of selling goods to the US.
So if they decided they wanted to quit accumulating dollars, what happens? If the US trade deficit went into balance, we’d replace the goods we bought from abroad with domestic production. That means a higher domestic employment rate since we are no longer “leaking demand” abroad. That means a higher growth rate and higher tax receipts. Both of those would improve out debt to GDP ratio. (Pettis provides a longer form discussion with more scenarios, but this is the drift of the gist).
The second misconstruction is acting as if GDP were static and impervious to budgetary changes, and therefore the way to deal with large debt levels is to cut spending. Unfortunately, empirical evidence solidly refutes this idea. The UK tried that 10 times in the last 100 years, and every time the debt to GDP ratio got worse. We are seeing the same results in Ireland and Latvia. In Japan, when the government got nervous about spending in 1997 and reduced expenditures, the debt ratio worsened.
Conversely, when an economy is slack (and that is the critical caveat), well targeted spending (and that does NOT mean tax cuts to the rich, who put too much of their excess dough in secondary securities markets) produces GDP increases such that the debt ratios do not worsen, indeed, they typically improve. The trick is, like steering a car into a skid, when to judge when you’ve reached the point that you can begin to change course. That’s one reason why automatic stabilizers, like unemployment insurance and food stamps, are so useful: not only do they target people in need and therefore likely to spend, but those expenditures fall off naturally when the economy improves. They don’t need to rely on Congresscritters to exercise discipline; the programs are structured to pay out less in a strong economy.
Now to the interesting and not widely noticed part of the S&P commentary. Even though we are pretty skeptical of the rating agency’s analysis, remember that they tend to be followers rather than leaders (as in they often issue corporate downgrades after spreads have widened). Thus a view like this is noteworthy (hat tip reader Lynn F; boldface ours):
Additional fiscal risks we see for the U.S. include the potential for further extraordinary official assistance to large players in the U.S. financial or other sectors, along with outlays related to various federal credit programs. We estimate that it could cost the U.S. government as much as 3.5% of GDP to appropriately capitalize and relaunch Fannie Mae and Freddie Mac, two financial institutions now under federal control, in addition to the 1% of GDP already invested (see “U.S. Government Cost To Resolve And Relaunch Fannie Mae And Freddie Mac Could Approach $700 Billion,” Nov. 4, 2010, RatingsDirect). The potential for losses on federal direct and guaranteed loans (such as student loans) is another material fiscal risk, in our view. Most importantly, we believe the risks from the U.S. financial sector are higher than we considered them to be before 2008, as our downward revisions of our Banking Industry Country Risk Assessment (BICRA) on the U.S. to Group 3 from Group 2 in December 2009 and to Group 2 from Group 1 in December 2008 reflect (see “Banking Industry Country Risk Assessments,” March 8, 2011, and ” Banking Industry Country Risk Assessment: United States of America,” Feb. 1, 2010, both on RatingsDirect). In line with these views, we now estimate the maximum aggregate, up-front fiscal cost to the U.S. government of resolving potential financial sector asset impairment in a stress scenario at 34% of GDP compared with our estimate of 26% in 2007.
In other words, S&P disputes the idea that extend and pretend is working, and sees that financial sector risks are rising. Put it another way: if the rating agencies can no longer support the official cheerleading, how much longer will anyone regard it as credible?