A mighty fall for U.S. economic prestige

By now every­one is aware that the U.S. gov­ern­ment has lost some­thing the coun­try has pos­sessed since 1917 — its “best-of-the-best” stamp of finan­cial approval from all major debt rat­ings agen­cies. Last Fri­day Stan­dard and Poor’s down­graded U.S. Trea­sury secu­ri­ties from AAA to AA+, sug­gest­ing the U.S. gov­ern­ment seems a lit­tle less likely to repay in a timely fash­ion both prin­ci­pal and inter­est on Trea­sury securities.

Accord­ing to S&P, the recent fis­cal impasse in rais­ing the U.S. debt ceil­ing is a prime exam­ple of the paral­y­sis that is afflict­ing pol­icy mak­ers. As well the U.S. eco­nomic growth out­look is highly uncer­tain, and no seri­ous efforts have been made to bring the tri­fecta of enti­tle­ments (Medicare, Med­ic­aid and Social Secu­rity) under con­trol and allow U.S. bor­row­ing needs to mod­er­ate over time. Finally, S&P indi­cated that an addi­tional down­grade over the next cou­ple of years could occur if Con­gress and the pres­i­dent fail to address our fis­cal prob­lems in a timely fash­ion. Seem­ingly, they are highly inter­ested in deci­sions made by the “super com­mit­tee” that must rec­om­mend pol­icy choices over the next few months before auto­matic across-the-board spend­ing reduc­tions take place under the debt ceil­ing agree­ment signed into law last week.

The Obama admin­is­tra­tion imme­di­ately responded to the down­grade by not­ing a $2 tril­lion mis­take by S&P, reflect­ing an improper base­line used to make its 10-year pro­jec­tions upon which the down­grade was based. S&P responded that the mis­take did not mate­ri­ally change its out­look and the gov­ern­ment was sim­ply using it as a smoke screen to hide its fun­da­men­tal inabil­ity to address seri­ous finan­cial failings.

For most of us, the real issue is not one of pol­i­tics and the accom­pa­ny­ing egos of the real­ity TV-like drama that is unfold­ing, but what is likely to be the short and longer term con­se­quences of the S&P down­grade. To be sure, try­ing to esti­mate the impact is highly prob­lem­atic, par­tic­u­larly given the lack of his­tor­i­cal prece­dent for the U.S. Of course, that won’t keep oth­ers (or me) from tak­ing a stab at pos­si­ble consequences.

To begin, it is impor­tant to real­ize that only one of the three major credit rat­ings agen­cies has down­graded U.S. gov­ern­ment debt instru­ments. The other two — Moody’s and Fitch — have con­firmed they still give the U.S. gov­ern­ment their high­est rat­ing, though a “neg­a­tive” out­look has been attached to those rat­ings. That is a fancy way of say­ing they are hedg­ing their bets and real­iz­ing they may also down­grade U.S. debt instru­ments in the future. Until that hap­pens, how­ever, the impact of the down­grade by just S&P is likely to be muted.

As well, despite the S&P down­grade to AA+, the abil­ity of the U.S. to repay its oblig­a­tions is still viewed as very high and thus investors around the world are still likely to invest heav­ily in Trea­suries. In part this “desire” to invest in U.S. Trea­suries is really a “need” to invest in such finan­cial instru­ments given the lack of good alter­na­tives. Presently, the few other major economies around the world of some sig­nif­i­cant size are lim­ited in their abil­ity to pro­vide an alternative.

The Euro­pean sov­er­eign debt cri­sis has caused the sta­bil­ity of euro-denominated finan­cial assets to be called into ques­tion. The yuan is not an alter­na­tive, since its value is tightly con­trolled by the Chi­nese gov­ern­ment and is not read­ily con­vert­ible on world cur­rency mar­kets. The Japan­ese yen has been ris­ing in value in recent months — despite the dis­as­ters in March — and the Japan­ese gov­ern­ment is respond­ing by attempt­ing to flood cur­rency mar­kets with yen to drive down its value so that Japan­ese exporters will not find their prod­ucts becom­ing pro­hib­i­tively expen­sive. Finally, other non-euro nations presently rated AAA (such as Aus­tralia, Canada and New Zealand) are far too small to effec­tively absorb the mon­strous vol­ume of funds which flow daily into world finan­cial mar­kets. In short, there are no good alter­na­tives to dollar-denominated asset, includ­ing U.S. Trea­sury securities.

So, will there be any impact? Over time, yes, pri­mar­ily in the form of higher inter­est rates that will need to be paid by the U.S. government/ businesses/consumers to raise funds. But even this is likely to take some time given the pre­car­i­ous state of the econ­omy. As of early Mon­day after­noon of this week, the stock mar­ket was in decline as investors pulled money out of equi­ties. And where were they plac­ing their money? Among other things, super-safe U.S. Trea­sury secu­ri­ties! How’s that for irony?

Dr. James New­ton serves as chief eco­nomic advi­sor to Com­merce National Bank and is an aux­il­iary fac­ulty mem­ber in eco­nom­ics and sta­tis­tics at Ohio State University-Marion. Dr. Newton’s views do not nec­es­sar­ily reflect those of Com­merce National Bank or OSU-Marion.

Posted by Jim Newton on Aug 9 2011. You can follow any responses to this entry through the RSS Feed. Comments can be made below.