The rating agencies are the whipping boys of the market.? Like princes who had a whipping boy to take the hit for their transgressions, so the rating agencies take the hit that should go to the regulators, which delegated their? credit-risk responsibility to the rating agencies.? That works out well for all, in one sense: the rating agencies make money, and the regulators escape blame.? What could be better?
But now we face another situation with the rating agencies, where they will finally downgrade the US Government from AAA.? Long overdue, particularly when one looks at the entitlement promises.
But people put up all manner of objections to the rating agencies doing what they should have done ten years ago.? Here is the big one:
The rating agencies never get it right
Not true.? On corporate credit, their ratings are highly predictive, and even yield insights into the movement of stock prices.? Now, if you are talking about securitized credit, you have to understand one thing: no one gets a debt market right until it has been through a failure cycle.? The rating agencies use what little data exists, usually from loans that are held on-balance-sheet, and apply them to loans that are originated and sold.? Doesn’t work that well, but who had better data, because it was a new practice?? Everyone failed on securitization, and only a few of us questioned it in advance.
With government credit, the rating agencies have been right for the most part.? Why?? For the most part, rating agencies are honest dealers when it comes to credit.? To be otherwise would damage their reputation.
Other Objections
Others talk about what the US or the EU could do to muzzle the rating agencies, because the downgrades complicate their actions.? I would say that the Rating Agencies are late if anything — the agencies don’t have much impact on their own.? The big impact is that not enough cash will flow to service debt and other demands on cash at the right time.
If the rating Agencies were muzzled, it would not change the cash flows one whit, except that there would be greater distrust from lenders, because the referees were forcibly silenced.
So what happens if the US gets downgraded?
Not much.? As I have said before, the ratings don’t mean much, except to regulators.? Yields shouldn’t move much, and if there is a sovereign ceiling at Aa2/AA, that will be the benchmark for all US yields, and corporate/municipal/securitized yields won’t shift much, because the economic reality hasn’t changed much.
What will change are investment guidelines that require Aaa/AAA investments.? They will reflect the lower top category, and not force investors to buy foreign AAA dollar-denominated bonds.
What happens if the debt ceiling isn’t raised?
Not sure.? There are lots of things that can happen:
- Prioritizing payments
- Not paying principal or interest on bonds (not likely)
- Issuing scrip (haven’t heard it yet, but who can tell, states have done it)
- Martial law is declared, and the Constitution is null and void (again, not likely)
A genuine full default by the US Government would have many ugly consequences, and should be avoided.? Prioritizing payments would be ugly, but could force our government to do the hard questioning that it has avoided for a long time — what are the priorities of our government?? What would we spend money on if we were deciding on priorities today, rather than the dead ideas of the past?
What, Me Worry?
I have concern over a lot of things, but the debt ceiling does not make it for me.? The bigger entitlement issues have been ignored for 40 years, and I have covered them for 20 years.? This is not the end, but the beginning of debates over where the resources of the US go, and how much is extracted from the populace.? The real test will come when Medicare is reduced, and how well the voters accept that.
David:
How can you say that the US should have been downgraded 10 years ago? Are you of the opinion that growth doesn’t matter? That a prudent level of debt-per-capita in Washington DC is the same as in Elmira, NY? What about demographics, productivity, and capital (in all its manifestations)?
Entitlements are not contractual, they have been enacted by legislative fiat. And what Congress hath granted, Congress can (and will) take away. I’m actually encouraged that the larger entitlements issues are on the table; rumor is that Tom Coburn has a $9.5 trillion 10-year plan in the works. That never could have even been aired 5 or 10 years ago.
But roll the clock back 10 years. If the economy *had* been able to sustain 4% productivity gains with 1% population growth, we wouldn’t be looking at the problems we are now.
David,
You’re and astute guy and I respect you (from afar) very much.
With that said, I think you may be falling prey to a very commonly held “innocent fraud,” which is that the U.S. can ever go bankrupt, default, etc.
As the monopoly issuer of its own nonconvertible, floating-exchange rate currency, the U.S. can never “run out of dollars” that it alone creates.
Unlike the Euro, a state, business, or household, the U.S. spends first by crediting private bank accounts, which is nothing more than changing numbers in a spreadsheet. They do not tax or borrow money from China to do this. The only functional constraint to U.S. federal spending is inflation.
This is also why Japan can continue to operate with a debt 2x the U.S., and despite continual fears that they will hit the wall, never seem to face the invisible bond vigilantes…because they are no bond vigilantes for issuers of their own currency.
Best regards
Chad
Chad & David,
Then can the government get around the debt limit simply by printing more money? Inflating the dollar would make it easier for the government to pay off its debts.
Best I can tell tho, Obama and the Republicans want to make life uncomfortable for everyone. If the government delays sending out checks for Social Security, Medicare, Medicaid, Food Stamps, Welfare, etc. might that cause panic at most banks? I find it hard to believe that that would happen even if Aug 2 arrives with no agreement, but it does seem possible. There are too many people in this country that are dependent on Government money and live precariously from one check to the next. If the government delays sending out money, even for just a few days, will these people starve?
Bodyworker
They cannot get around the debt limit, which is just a way of saying they cannot add to the cumulative deficit.
The real issue is not default, per se, but as you surmise how much they cut spending. Cutting spending or raising taxes have the same effect of removing net financial assets from the nongovernment sector. This is deflationary and slows the economy, which makes the real debt burden higher.
Incidentally, the Fed doesn’t print money, they only exchange assets with the banks…swap short term cash for longer term bonds. No net change in financial assets in the private sector. Huge misconception.
The printing actually occurs whenever the govt spends by crediting bank accounts. The reverse is true when they tax — removes money. This is well described in the MMT literature describing modern monetary operations.
Best