Meanwhile The Boys Continue To Make Fun On S&P

Paul Krugman has something interesting to say about the S&P report.

    OK, so Standard and Poors has warned that it might downgrade the US one of these days. At first read, what it says doesn’t seem too silly: it lays stress, rightly, on political gridlock. The point should be that the US is perfectly capable both of running large deficits now and getting its fiscal house in order over time; but not if the parties cannot agree on any kind of solution. What we do to spending this year or next is irrelevant.

   That said, it’s worth remembering that S&P downgraded Japan in 2002 ...

    Japanese bonds became known as the “trade of death”, because people kept betting on an interest rate rise, and it kept not happening.

    So, no big deal.


From Dave Lindorff later in the day:

    At least one economist burst out laughing on hearing about the S&P announcement. “They did what?” exclaimed James Galbraith, a professor of economics at the University of Texas in Austin, who formerly served as executive director of the Congressional Joint Economic Committee. “This is remarkable! It certainly will confirm the suspicions of those who have questioned S&P’s competence after its performance on the mortgage debacle.”

    S&P, as well as the other two big ratings firms, all notoriously failed completely to spot the looming disaster of the banking collapse and financial crisis, and famously issued A ratings to mortgage-backed securities that later proved to be virtually worthless paper, as well as to the banks that had loaded up on the financial wreck.

    As Galbraith explains it, “US debt consists of bonds issued in US dollars, which I assume the S&P analysts know (such Sarcasm) . How can the US possibly default on its own currency? The obligation is in nominal dollars, which is to say when the bond retires, the US issues a check in dollars to cover it.”

    Since the US prints its own currency (or actually just issues electronic payments to create new money) whenever it needs it, as Galbraith puts it, “As long as there is diesel fuel to power up the back-up generators that run the government’s computers, they will have the money to back their own bonds.”

  Anticipating such a criticism, S&P issued a FAQ sheet about its decision, and in answer to the question of how a country could default on bonds issued in its own currency, writes, “We consider having the world's reserve currency to be a strength to the U.S. government's credit profile. However, there can be reserve asset demand for the currency of a sovereign that is experiencing a weakening of its credit profile, as in the case of Japan (AA-/Stable/A-1+), which Standard & Poor's downgraded most recently in January 2011.”

    This however, just dodges the question, because after all, the Japanese Yen is not a reserve currency. Oil, for example, is not priced in Yen, it is priced in dollars. Third world countries, when they issue debt not in their own local currency, generally use dollars, not Yen, except for instance when they are funding a project involving Japanese companies.

    So what’s going on here?

    There would seem to be only two possibilities:

    Either S&P has been pressured by powerful Republicans and/or Wall Street Bankers to issue this warning, in order to add to national hysteria about the national debt and win more drastic cuts in social programs, or S&P is simply blowing it again.

    “Political shenanigans cannot be ruled out,” says Galbraith. “That’s what lawyers would call the ‘rebuttable presumption.’ After all, who benefits? The Republicans and perhaps the banks. But of course the other possibility is that S&P doesn’t know what it’s talking about, and after their disastrous missing of the mortgage bubble, that’s quite possibly what it is.”

Richard Koo of Nomura has written before that ratings agencies don't understand how government debt functions in a deleveraging cycle, or a balance sheet recession.

From Richard Koo:

What Japanese market participants understand that Western rating agencies do not is that fiscal deficits generated during a balance sheet recession are the result of economic weakness triggered by private-sector deleveraging, and that the private savings needed to finance those deficits are by definition made available at the same time.

In other words, such conditions lead to a substantial surplus of savings in the private sector. What makes an economy under such conditions fundamentally different from an ordinary economy (i.e., one that is not in a balance sheet recession) is that those savings are plentiful enough to finance the government’s deficits.

Corporate savings (and personal savings to a lesser extent) have boomed since the recession, and it's that excess cash the U.S. government can continue to make use of while the country is deleveraging to keep the economy from shrinking.


And ratings agencies, failing to understand this situation, have got their downgrades wrong every time in Japan. Koo has compared ratings agencies to a "doctor who cannot even identify his disease."

The S&P may have just kicked off the beginning of a U.S. debt downgrade round that will put pressure on the government to cut spending when the economy is weak. We've already seen how that's working out for the UK.