Another Week, Another Crisis

By Charles Webb

Standard & Poor's was kind enough to send us home over the weekend with a credit downgrade of U.S. long-term debt. This would have been unimaginable only a couple of years ago, but here we are. Now we're faced with the first day of trading in what many think of as a new financial world, a world in which U.S. debt backed by the U.S. dollar is no longer the unquestioned safe haven in troubled times.

So what does all of this actually mean? Well, we've written fairly extensively over the past few months on the subject of sovereign debt and the dollar and have touched on the subject of a possible downgrade. Now that it's here, it's a good time to put all of the pieces together.

The first thing that is important to acknowledge is that a downgrade on sovereign debt is very different than a downgrade on corporate debt. A downgrade in the corporate world is serious stuff. It directly affects the rate a company will pay when it borrows money, either from a bank lender or from the bond market when it issues debt. Nations, on the other hand, issue their debt via an auction process and the interest rate paid on those bonds is strictly based on the bids received. Thus, their cost of borrowing is a function of the demand for their bonds. That demand is only marginally (at best) influenced by a credit rating agency. For a major economic power like the U.S., the rating is meaningless. What we have there is a moral defeat and not a financial one.

I think it's best to frame this discussion more as a political failure than a financial one. No one, including S&P, thinks that the U.S. will default on its debt. The only risk that holders of U.S. treasuries face is what I earlier described as a soft default. That is to say that higher interest rates and a weaker dollar will hurt current bond holders by devaluing the purchasing power of their future interest income. This is no small thing to foreign investors that hold trillions of dollars in treasuries. There has been a real concern in recent years about holding U.S. dollar denominated assets when the Fed has been pursuing a weak dollar monetary policy while also running massive fiscal deficits. The irony surrounding S&P's downgrade is that there is absolutely nothing in their announcement that hasn't been widely understood for at least two years. That's why I call this a moral defeat or simply the cherry on top of a pile of bad news.

The Financial Fallout

Wall Street often thinks of macro trading strategies as risk-on or risk-off. Risk-on usually means buying stocks- i.e. going long risky assets. Risk-off is the opposite and usually leads to a flight to the safest asset - i.e. U.S. treasuries. What does a risk-off trade look like now? Well, it turns out that it looks like it always has. Treasuries are rallying driving rates down. Not exactly what the textbooks teach. This is why we don't think this downgrade will actually lead to higher consumer rates or hurt the economy long-term. The economic damage will result for the same reason as the downgrade and not from the downgrade. Obviously, this is too much debt and the prospect is for even higher debt levels in the future.

Once again, we are benefiting from the focus on Europe. Due to their own debt chaos, the U.S. treasury market remains the only game in town. There certainly are other nations in better fiscal shape, but those markets simply aren't deep enough to accommodate the required liquidity. Quite simply the world doesn't have anywhere else to park $10 trillion.

Short-term we expect to see a lot of volatility. That is to be expected as market participants digest this news. We still view this as headline risk and are far more concerned with the fundamental underpinning of the economy. The only way this downgrade could affect things long-term is if it leads to higher rates. We just don't see that happening.

Make no mistake, stock prices over the last few weeks, today and in the coming weeks have and will be driven by fears of slowing GDP that could lead to another recession. Market sentiment is pretty low right now. This downgrade is only exacerbating that feeling. As we've seen in the past, attitudes can turn quickly.

Don't be surprised to hear of other downgrades over the week. Because the federal government backstops a lot of other debt issuers, this downgrade is going to trickle through. We're already seeing rating changes on Fannie Mae and Freddy Mac, as well as several other agency debt issues. Once again, I don't expect this to have much of an impact. In fact, spreads on many of these bonds, including treasuries, have widened over the past couple of months. This implies that the market has been pricing in this rating change for weeks.

The Political Fallout - warning: if you're politically sensitive stop reading here. This is about to get very opinionated.

As I stated earlier, this event is primarily a political failure. Standard & Poor's really didn't downgrade our debt as much as they downgraded our fiscal policies. This is the result of an abject failure of leadership in this country. The federal government has run deficits for decades. Not surprising as that's what governments do left unchecked. Only from time to time has Congress been serious about addressing our country's debt and spending level. Even then, they usually just gave it lip service. The last time any real effort was made was during the Clinton presidency when the Republicans took control of the House and Senate.

Over the ensuing years of Republican control, the party in charge became drunk with power (because this is what politicians do) and went on a spending binge. Government spending exploded with all of the fresh tech-bubble tax revenue in the late 90's. We then had to suffer through the Bush presidency that never saw a spending bill worth vetoing. Add a couple of wars and we were off to the races. From there we then went to a Democratically controlled Congress and Senate led by a very activist arm of the party. Two years later president Obama was elected.

Federal spending has expanded exponentially to the point that we now borrow 40 cents of every dollar. This trend has been particularly egregious over the last three years - all in the name of stimulus. So let's take a moment to talk about stimulus spending and how it's supposed to work. I'll try to do this without getting lost in the weeds of economic theory.

By nature, government fancies itself as the solver of problems (real or imaginary). As such, Keynesian economic theory has always been very popular in governments around the world. Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes. Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize the business cycle. One might call a recession an inefficiency. Keynesian economic theories were first presented in The General Theory of Employment, Interest and Money, published in 1936.

Part of this theory incorporates the concept of the multiplier effect. This theory believes that, for a number of reasons, for every dollar of government spending you will get a larger number back in GDP. The president's first set of economic advisors seemed to think that we would see a 1.5 multiplier. This means that for every dollar they spent, the economy would see a $1.50 increase in GDP (I'm not sure where this brain trust came up with that figure but it seems to be the same place they got unemployment not exceeding 8%). From here the Stimulus Bill was born and all other policy responses were based. In all fairness, stimulus spending was Bush's first response too, although nowhere near in size.

What we have seen in the past two and a half years has been a giant experiment in Keynesian economics and the results are not looking promising at all. This experiment has come at a great cost to our public debt and, in my opinion, not shown much in the way of working. Not only have we had trillions of dollars thrown at the economy, but we've also vastly increased baseline expenses in perpetuity. This is at the heart of the S&P downgrade and the pushback from the public at large.

One thing that I find very disheartening is the response from the White House. Instead of honestly critiquing their results, the reaction is to blame others and want to double-down on this experiment. To be sure, all the president's men came out in full attack mode this past weekend blaming all of this on S&P's analysis. Absurd. Is there anything that S&P said on Friday that everyone else doesn't already know? S&P essentially declared that on present trend the U.S. debt burden is unsustainable, and that the American political system seems unable to reverse that trend. This is not news.

So after trillions spent on "investments" like cash for clunkers, cash for caulkers, cash for first time home buyers, making work pay, cash for green energy, cash for high speed rail, etc., we now have the latest grand idea - an infrastructure bank. This is simply code speak for more stimulus spending. It's a "bank" funded with - can you guess? More debt to invest in our infrastructure. Sounds very shovel ready in my opinion.

To me it sounds like these people are so very in over their heads and out of ideas. I've never been a big believer in the multiplier effect. I think instead all it does is postpone the inevitable. All of these programs have done nothing but drag out this recession/recovery. A great example was the housing price bust. Untold amounts of money were paid to folks to buy homes sitting on the market and thus create demand. It worked. That is until the program ended and then prices fell yet again. Interestingly, they fell by about what the credit was. So instead, the housing price decline lasted a couple more years with prices ending up at basically the same place. In the meantime, our kids have just paid the down payment on a stranger's home.

The bottom line is that the spending must stop and their other favorite solution, raising taxes, would be counterproductive. It's unclear to me how you fix a spending problem by throwing more money at. That's a bit like solving alcoholism with another drink.

This leads me to another complaint. The blame game isn't going to help matters. I'm perplexed to see time and time again the president go on national TV demagoging entire industries and large segments of our population. One of the other themes seen this weekend was that the downgrade was the fault of the Tea Party movement. I fail to see how a movement that arose out of the desire to curtail spending is in anyway responsible for the situation we find ourselves in today. Of course, what the administration is really saying is that those members of Congress aligned with the Tea Party objected to a balanced approach - i.e. raising taxes. Once again, this problem didn't spring up because of any tax shortfall thus the solution won't be found there. At best, higher taxes would only slow (and not by much) the decline in our fiscal situation. There just aren't enough corporate jets in this world or hedge fund managers to make a difference.

S&P did mention in their report that one problem they saw was an unwillingness to raise taxes. One important thing to note here is that they are not in the job of writing economic policy. They would rather see the deficit gap close as quick as possible regardless of the long-term consequences - give the man another drink and he'll be quiet for a while.

In Summary

This too will pass. If the politicians won't adequately address the problem, the market will force the issue. This is a wakeup call to Washington. The president used to say that elections have consequences. This downgrade will have consequences too and it won't be financial but instead will be felt at the polls. We should all be furious with everyone in Washington who contributed to this mess. Good credit is nothing to play around with and is very hard to get back once you've lost it.