Here we go again….
As the Obama administration is quietly working towards a “Grand Bargain”, which is the current branding for “let’s put the middle class on the austerity rack just when the economy looks depression prone”, rating agency Fitch does its part by lobbing in a “the US needs to get its fiscal house in order” message.
Readers may recall we went through this drama at the end of last summer. S&P huffed and puffed about a downgrade and the financial media obligingly went into a complete panic. Yet what happened when S&P pulled the trigger? As we predicted, pretty much nothing. In fact, US Treasury yields have continued to fall. Yet the Wall Street Journal shamelessly misreports what happened:
A potential downgrade could send shockwaves through financial markets, similar to how S&P jolted markets last summer when it stripped the U.S. of its top credit rating.
No, sports fans. The market upset was BEFORE the downgrade. And it also happened to coincide with an acute episode of stress in Europe, making it hard to parse out how much of the stock market reaction was due to concerns over Europe v. downgrade fearmongering. The downgrade was a non-event. Treasuries rallied, which is the exact opposite of what the overwhelming majority of commentators said would happen. This was worse than a Y2K scare (at least there was real remediation prior to Y2K; this by contrast, was simply overhyped).
It isn’t hard to understand why, that is, if you are interested in understanding. A country that issues its own currency can always pays its debts. It may choose not to, as Russia chose not to in 1998, stunning investors because it had a very low government debt to GDP ratio (my recollection is below 20%) and investors were blindsided by its move. The US does have political constraints, in that fiscal actions are subject to Congressional approval and the US government has financed itself by issuing bonds, rather than by simply having the Federal Reserve “print”. And as was discussed at considerable length around the time the US last looked like it might bump up against the debt ceiling, there are ways operationally to get around that, but the Obama administration has chosen to lash itself to the mast and refused to consider them.
The risk that a country that issues its own currency does run when it overdoes deficit spending is inflation. Not only are we not at risk of inflation, but we are in a situation where government deficit spending is warranted. On the lack of inflation risk, note that government bond yields have continued to fall since the S&P downgrade. Investors are clearly worried about deflation; in deflation, the place to be is cash and in government and other high-qualty bonds. The TIPS yield curve has gone negative, signaling that investors expect the downturn to worsen. Recall, conversely, that when we had the 1970s stagflation, we had massive deficit spending in the 1960s and early 1970s when the economy was already growing smartly, PLUS labor had strong bargaining power which meant that when costs rose, workers could get wage increases, which then led companies to raise the prices of their products (this is called “cost-push” inflation). And we also had the oil price shock.
By contrast, instead of robust growth, we have both consumers and businesses reducing debt levels. When the private sector is net saving, government needs to accommodate the saving by running a deficit. The only way the private sector and government sector can save at the same time is when a country runs a trade surplus, and that’s not where the US is. If the government tries saving when the private sector is saving too (and you don’t have the trade surplus to square the circle), GDP and wages contract, as Greece, Ireland, Latvia, Spain, and Portugal are demonstrating.
Now deficit hawks might argue that the S&P downgrade didn’t have the impact it should have because investors still could rely on Moody’s and Fitch and treat US government debt as AAA. They contend that once two agencies have downgraded the US to AA, many investors required to hold AAA assets would be forced to sell.
That’s less of a risk that it seems. The media reported on the eve of the downgrade that a lot of fund managers were getting opinions of counsel to cover them in case that took place. And one of the biggest uses of Treasuries is as collateral for derivatives positions. Counterparties want a very safe and highly liquid asset, and Treasuries will remain the best game in town, no matter what ratings agencies, who don’t exactly have stellar track records, say about the matter. The very worst you might see is some short-term price moves, as particularly concerned investors sell while others pick up the bonds as artificially cheap.
Jane Hamsher argued that the S&P was threatening the US government as a way of warding off reforms. That sounds like a stretch until you look at the evidence. And the ratings agencies have another motivation: having lost credibility for missing the boat repeatedly in the runup to the crisis, acting aggressive on the Treasury front garners them favorable headlines from a press that has been conditioned to take budget scare-mongering more seriously than it ought to. But the reality, as with US mortgage bonds, is that the ratings agencies are not covering themselves with glory on this one.