karl-henrik pettersson


Filosofiska tankar om företagande och ekonomi

Vilket samhälle vill vi ha? Hur mycket marknad? Hur mycket politik? Varför dessa ekonomiska orättvisor?

Notes on a society in crisis (6): The downgrade of the U.S. government debt

On April 1st, my book,” Dagbok från USA”, came out in Sweden. It will also soon be published in English (as an e-book for Kindle and for other readers) with the title: “Diary from the United States – Notes on a society in crisis“. As an appetizer for English speaking readers, I will the coming weeks publish some excerpts from the book.

“An earthquake in the American political and financial landscape”

Yesterday Standard & Poor’s (S & P), the most prestigious rating institution in the world, downgraded the U.S. for the first time ever – from the highest AAA rating on the long-term government debt to the second highest rating, AA +. It may seem, both figuratively and literally, like a small step. Nothing could be more wrong. It’s a giant step. I would call it an earthquake in the American political and financial landscape. It will almost certainly have repercussions far beyond the United States. S & P’s decision on August 5, 2011, will end up in the history books.

Quite apart from the impact the downgrade will have on the financial markets on Monday – and it will at best mean a major worry for market participants, and at worst a major fall in the financial markets which will continue for weeks – the S & P decision will also have other implications in the short term. Among other things, a whole host of financial institutions can be forced to make changes in their asset portfolios. It might affect insurance companies, pension funds, and the semi-federal mortgage institutions, Freddie Mac and Fannie Mae. These institutions will at least have to start preparing for a new age (Moody’s and Fitch, the other two major rating agencies, continue to give America’s long-term government securities the highest rating, which in effect is providing some breathing room). This applies to all financial companies that according to their statutes must have a certain percentage of AAA assets on their balance sheets. It isn’t hard to imagine that such a “remake” will have effects down the road.

The downgrade has structural consequences for the financial system. Sovereign bonds are expected to be risk-free, and U.S. government bonds, U.S. Treasuries, are expected to be the most risk-free of the risk-free. When this no longer applies, it will obviously have repercussions for the financial sector. Among other things, the banks’ capital adequacy rules, what is sometimes called the Basel rules, will have to be tightened up. To put it more concretely, if government bonds no longer are without risk, the banks need more equity, a larger capital base. So far the banks have been allowed to increase their holdings of sovereign bonds without increasing the capital base correspondingly (which, incidentally, is one of the main reasons why the large European banks are so heavily exposed to government bonds). In addition to structural changes brought about by the S & P downgrade, one can imagine that it also will be more expensive to finance the U.S. national debt; the dollar should, all else being equal, lose somewhat in relative value.

Why did S & P downgrade the U.S. credit rating? There are some concrete grounds presented by S & P. For example, the agreement in Congress the other day [referring to the congressional decision on debt ceiling August 2, 2011] to cut the federal budget by nearly $ 3,000 billion within a decade, is, according to S & P, at least $ 1,000 billion too little. However, the basic reason for the downgrading concerns the crisis in the political system. S & P no longer believes in American politicians’ ability to handle the situation. They simply will not, says S & P, produce a credible plan to bring down the U.S. national debt. S & P is surprisingly clear in its statement:

The political brinkmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently. Republicans and Democrats have only been able to agree to relatively modest savings on discretionary spending…

Is the S & P’s decision justified? Absolutely – for three reasons. First, the S & P is quite right that the American political system is seriously paralyzed. There’s a risk that the necessary decisions about the national debt that must be made within the next few years will not be made. Recent events do not bode well. It’s quite remarkable that the politicians in the world’s most powerful and prosperous country is delivering such a poor solution to the debt crisis as was presented on August 2nd. The U.S. politicians present themselves, figuratively speaking, in underwear before a raised curtain as a laughing stock to the rest of the world. Second, it was forewarned: S & P announced in April 2011 that a downgrade was possible.

The third reason is more speculative. But at best, the downgrade could prove so humbling and upsetting for the U.S. that we will see a political sobering.

First published (in Swedish): August 6, 2011

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