WHY THE U.S. OF AA MATTERS
By Niels Jensen, Absolute Return Partners
We have never published the Absolute Return Letter before in August and, hopefully, we will never have to do it again; however, the unprecedented events of recent days and weeks have forced our hand. I will make it short, though. August is for reading, not writing.
Unless you’ve spent the last few days on another planet you will know by now that Standard and Poors chose to downgrade U.S. sovereign debt to AA+ last Friday evening. A U.S. downgrade is, in itself, almost meaningless. A nation that issues debt denominated solely in its own currency and which is in full control of its monetary policy, cannot default unwillingly. Nations default because they run out of foreign currency to service their debt, but the U.S. doesn’t need foreign currency to service its debt. One could thus argue that the rating agencies shouldn’t even bother to rate U.S. sovereign risk. But they do. And one of them has now decided that U.S. sovereign is no longer AAA.
So what does it mean? Near term, other U.S. financial institutions (Fannie Mae? Freddie Mac? JP Morgan?) will be downgraded as a result – perhaps as early as today or tomorrow. Following that, if Standard & Poors wants to maintain whatever credibility it has left, it will probably have to downgrade a few sovereigns as well. France springs to mind; it is not far behind the US as far as profligacy is concerned, and it may prove difficult for Standard and Poors to justify the AAA rating it currently assigns to France.
If France is downgraded, a number of French banks will almost certainly be downgraded, following which other European banks will face the same destiny. Such a scenario has the potential to cause calamity across Europe. The 90 European banks which recently went through the (so-called) stress test organised by the European Banking Authority need to roll a total of €5.4 trillion[1] (!) of debt over the next 24 months. A massive amount even during the best of times. Probably undoable during times of stress. As Ambrose Evans-Pritchard, in consultation with Willem Buiter of Citigroup, pointed out in the Daily Telegraph over the weekend[2]:
“…the issue is not how long Italy and Spain can ride out the storm in bond markets. There would be a banking and insurance crisis long before sovereign defaults came into play, simply because the fall in bond prices on the secondary market is causing carnage to bank books (among other transmission mechanisms).”
With its downgrade of U.S. sovereign debt, Standard and Poors has started a chain of events which can only make things worse in an already crisis hit eurozone. For that reason, the decision to downgrade was not only badly timed but also ill considered; that it was probably justified is of little relevance at the moment.
In another development this morning, the ECB has announced that it is expanding its bond purchasing programme to include the entire eurozone – thereby implying that it is now buying Spanish and Italian government bonds. The effect has been immediate with Spanish and Italian 10-year bond yields falling 60-70 basis points. European stock markets, on the other hand, are not visibly impressed. After an initial rally, most markets are now down as investors fret over the longer term growth outlook in the eurozone.
Germany’s role in all of this is pivotal. If you have any doubts, look at chart 1 below. Germany has almost single-handedly carried the eurozone through the crisis so far. Germany, however, demands responsibility from its troubled partners (which is fair enough). Merkel knows that with the next German parliamentary elections little more than a year away, domestic politics will increasingly set the stage for her in the months to come. She knows she is in a mine field and will have to step carefully.
Chart 1: Claims of eurozone members from cross-border payments (€ billion)
Source: ‘Europe on the Brink’, Peterson Institute of International Economics, July 2011
In German culture, responsibility equals austerity, but austerity translates in to slow growth, and slow growth is the last thing the troubled eurozone countries need right now. There is thus a fundamental clash between the demands made by Germany and the needs of its partners. For precisely that reason, our political leaders need to think out-of-the-box, if the eurozone is going to survive this crisis. Here is what I think is needed:
- Establish a credible lender of last resort. The EFSB with €440 billion of fire power[3] is a bad joke. Italy resides over the third largest bond market in the world with €1.8 trillion of sovereign debt outstanding, €700 billion of which must be rolled over the next 3 years. We estimate that at least €2 trillion would be required to make the EFSF credible.
- Get the debt restructuring over with. The current policy of ‘pretend and extend’ is extremely damaging, and the sooner our political leaders bite the bullet and accept a haircut is required on Greek, Irish and Portuguese debt, the better.
- Support the banking system, not the sovereigns. A haircut of 40-60% on Greek, Irish and Portuguese sovereign debt will undoubtedly put several banks in to trouble. If the banks go down, we all go down, so supporting them is critical. Where does the money come from? From the same sources which would have provided the funds to prop up the sovereigns (which is no longer required, following the haircut).
- Eliminate red tape. Labour market reforms are required across the eurozone. The Spanish prime minister will tell you he has already done a lot to make Spain a more productive country. The reality is that he is less than a mile into a marathon run in the Gobi desert. This will be painful but utterly necessary. Other reforms will also be required. The September letter will focus on one particular idea I have which could revive residential property markets around the world. Stay tuned.
- Think the unthinkable: fiscal union. I do not for one second believe a monetary union can survive longer term without full fiscal integration. Throughout history, there is not a single successful example. The question is whether Merkel can convince her countrymen (including herself) to join a fiscal union with countries which have proved terribly inept at managing their fiscal affairs? I suspect the answer is no.
The eurozone is well and truly in Dire Straits (for reasons which are largely self imposed). Only time will tell whether the political leadership in Frankfurt and Brussels can deliver Brothers in Arms or if it will all be Money for Nothing. Thus far they have been pretty good at delivering rhetoric, but rhetoric has no staying power, and their willingness to take tough decisions remains unproven. Today the ECB is buying Italian and Spanish government bonds. Let’s see what their appetite is like when they have spent €1 trillion and markets remain fragile. For this and the other reasons I have stated previously, my money remains on a complete restructuring of the euro.
Niels C. Jensen
[1] Source: ‘Europe on the Brink’, Peterson Institute of International Economics, July 2011
[2] http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100011278/please-europe-either-put-up-or-break-up/
[3] As the EFSB will be keen to protect its credit rating, only about €250 billion of the €440 billion in the rescue fund will in fact be available for lending purposes.
25 Comments
Gotta hand it to Beers. He’s been out front in creating two crises that didn’t need to happen and would have been less likely without S&P pushing its agenda. He should already be in the clink for taking what were essentially bribes to rate toxic waste tripleA in the lead up to the GFC, not to mention the monolines, Lehman, etc. At least the guy has world-class chutzpah.
Niels,
Your letters are very insightful, and I read them whenever Cullen posts. Here’s what I don’t get, you state “One could thus argue that the rating agencies shouldn’t even bother to rate U.S. sovereign risk. But they do. And one of them has now decided that U.S. sovereign is no longer AAA,” and then just a few short paragraphs later you say “For that reason, the decision to downgrade was not only badly timed but also ill considered; that it was probably justified is of little relevance at the moment.” Which is it? As an avowed MMTer, I agree with you on the first point. It seems logically inconsistent, therefore, to hold that first idea in your head and still think the S&P downgrade was “probably justified”. Can you please clarify?
Thanks.
Agree Niels, there’s no way out here bar a Euro restructuring or elimination. Fiscal union will not happen. Floating exchange rates between sovereigns of the eurozone must be reinstated. Given that the eurocrats are so emotionally, physically and materially invested in their dream of a united Europe, they won’t let the euro go down without a fight, so I expect to see it backtrack to an earlier state. A few options come to mind:
1: Prune away the necrotic tissue. Either the core cuts away the PIIGS, allowing the PIIGS to revert to previous currencies and devalue, or the core leaves the PIIGS on the euro and cuts itself away to goes back to previous currencies or create a “Neuro”: a two-tiered euro system (quite likely).
2: The euro is elevated to SDR-status and used for international trading purposes as it provides more stability than individual currencies. Member nations revert to previous currencies and contribute to the Euro basket with weightings controlled by the ECB. Eurocrats would love this as they still get to exert their vile influence on the member economies of the eurozone.
3: The euro is scrapped entirely and we go back to previous currencies. The difference this time around being that the EU imposes a ban on money changing for profit between member nation currencies, thereby helping to prevent formation of barriers to trade. To help facilitate this, the ECB can maintain and distribute reserves of each member nation currency to help ease shortages should they arise and mandate that member banks provide the service.
Just get rid of this damn intra-EU currency peg and things will sort themselves out within a few years.
Be it 1 or 2 or : it will cost a lot to germany since going back to old ccy but keeping euro denom debt would be suicide. i.e. it would rhyme with default…and germany will have to monetise by supporting its banks. Corporates do not have the same levy as the sates and foreign law debt will be claimed…i.e. company integratedin global economy (not much for greece) will have their balance sheet wiped out by debt (unless they have non local assetsand not much non local debt)
how would the 2 tiered euro work ? it would require important top tier euro central bank intervention in order to avoir losing too much on second tier debt. It would rhyme with restruc or partial/total default.
No one can afford an Italian default in europe…i’m not sure Italy would be happy to get out of euro with 100% of its euro debt still alive. Accepting to convert it to Lira would be equivalent to accept partial default.
in any case, all countries, be they good or bad, have their knees already so deep in the sh** that eurobonds and fiscal unity is the only solution…
I do like all your scenario but the transition costs are too high i think…
I guess the question is, does the transition cost exceed the cost of not transitioning? Obviously, I’m biased, so I think that it doesn’t.
And by cost, I don’t just mean financial, I also mean political and social. Europe has operated in the past quite happily without the euro, so I’m inclined to believe it can revert to that state peacefully, with manageable expense and that things will blow over reasonably quickly.
If the current course is stayed and fiscal unity fails to be achieved, then I think things get very messy and costly (in all categories).
On a different topic, I have a vague instinct that something big will happen to the Eurozone in mid 2013, when the ESM is due to be engaged. Probably an exclusion of one or more nations from the euro. Do you have any feeling on this?
Angar Belke, an important German economist (DIW, IBES) also sees the downgrade of the US to be an important Euopean problem (via France). His solution:
“Flooding the markets with unlimited bond purchases destroyes the resuming confidence in Central Banks. Just that will cause lasting turmoil in the capital markets. National „dept ceilings“ (which can be better democratically legitimized in the EU by the parliments of the members than by transfer of fiscal discipline to some supranational entity) and reforms that enhance competitiveness are the means to get out of the problems.”
(my not very strict translation)
http://www.handelsblatt.com/politik/international/auch-die-fed-kann-bankrott-gehen/4474324.html?p4474324=all
Another twist of the US downgrade might be, that rating opinions lose their prestige. If the US is not top grade, what is? Perhaps the EU was done a favour that way…
Pierce,
Let me try my best. In effect I made two statements. The first (it was not only badly timed but also ill considered) refers to the fact that an already fragile situation in Europe may be further undermined by the US downgrade). The second part (it was probably justified) simply refers to the fact that the US administration deserved a reminder that their current policy of spending as if there were no tomorrow cannot continue for much longer. I can see why you think I am being inconsistent, but I don’t think that is the case. The fact that the credit rating is largely irrelevant for the US doesn’t imply that reckless spending can continue ad infinitum.
Just one more note. I fully understand that when the private sector chooses to save rather than spend, the government needs to step in with increased public spending. Otherwise the economy will contract. But the USA government has chosen to allocate most of its spending to transfer incomes which carry a multiplier of near zero. Transfer incomes buy votes but not prosperity and Obama needs to realise that (but he is not alone in making that mistake).
Niels,
Thanks for taking the time to respond, and in such a level manner .
I don’t have enough experience to speak intelligently on policy prescriptions, so I’ll leave any debate there between you and any other commenters (should there be any), but I appreciate your clarification.
Thanks again.
“But the USA government has chosen to allocate most of its spending to transfer incomes which carry a multiplier of near zero.”
Do you mean transfer payments? Social security, unemployment benefits, food stamps? From what I understood, these were actually the most likely to be spent into the economy, so, how can they have a multiplier of near zero? Or did you mean something else?
From what I’ve read, food stamps are the quickest way to get money back into the economy, with the highest multiplier effect.
Sorry Peter – I meant transfer payments. It is late in the day here in Europe and it has been a looong day. But the multiplier on transfer payments is still near zero unlike infrastructure spending (better roads, airports, public transport, etc.) which is far more beneficial for the economy in the long run.
I agree Niels. If they had downgraded us due to the risk that we are in essence reducing the standard of living in the USA then that would be one thing. But they really believe there is an inability to pay. They see a traditional solvency risk as exists for a business or household.
I think it’s an extremely important distinction to make. Do we deserve to be AAA based on the govt’s maintenance of its citizen’s standard of living? Probably not. But do we deserve a AAA based on ability to pay. Most certainly.
If they’re going to rate sov credit they should be much clearer in their process. Seeing the President of S&P compare the USA to France today was about all I needed to hear to confirm that they are clueless.
Niels, I doubt this is the case, but I am willing to see your evidence. That said, transfer payments don’t need to carry any multipliers attached – these are basic safety nets any rich society should accommodate for its disadvantaged members. I am surprised you’re not talking about the real wasteful spending – the wars (spending on destroying things!) One category of transfer payments that is a wasteful spending is our govt health care – Medicare. But it is not because it is a wastful program on its own – it is because our whole healthcare system is broken. MC is actually more efficient than any private insurance. Cutting MC will drive more people into private debt – this is not only not fixing the problem, it is exacerbating it.
That’s pretty accurate. Cross threading from elsewhere, you also talked about the problems caused by matching economic expansion with credit expansion (no new NFA) versus chartalistic expansion. It all fits the same theme: America’s problem is that it over-privatized. The Thatcher/Reagan philosophy, that the private sector *always* does *everything* more efficiently than the government is a total myth and in the relentless drive to supplement or complement what should be done by a government with privately controlled equivalents, inefficiencies have emerged all over the place in conjunction with harmful misallocations and concentrations of capital.
I’m not advocating full-state ownership as this is equally disastrous, I’m just advocating a return to a happy medium. America would benefit enormously from it. Target number one, healthcare.
Back to monetary matters, I’m curious of what your opinion is regarding regulating credit expansion in direct relation to the current account. Details here: http://www.buoyanteconomies.com/CAD_Formula.htm
But the multiplier on transfer payments is still near zero unlike infrastructure spending (better roads, airports, public transport, etc.) which is far more beneficial for the economy in the long run.
Like the poet said, man is the measure of all things. Building cathedrals instead of feeding the poor is bad economics and (I’d argue) bad theology.
I still don’t see the link between downgrading U.S. debt and subsequent downgrading of European debt. It may well happen, but either I need a few more coffees or the justification for such a linkage has not been properly explained.
Someone please explain for me!
“But the USA government has chosen to allocate most of its spending to transfer incomes (payments) which carry a multiplier of near zero. Transfer incomes (payments) buy votes but not prosperity and Obama needs to realise that (but he is not alone in making that mistake).” Amen.
$880 billion in “stimulus” went up the aggregate demand chimney instead of going to capital investment. FDR bought us the Hoover Dam, the TVA, parks, roads, bridges the CCC etc. and we are still living well off of them. Obama will be remembered for treating $880 billion like he was a Chicago alderman handing out turkeys to favored constituents at Christmas. The real economy, the supply side and production matter; aggregate demand is part of a sterile equation disconnected from the real world. This will be Obama’s undoing.
That’s really funny, because a lot of people talk of government always misallocating resources when it spends on stuff. I don’t agree, but that’s what you hear most. That if the govt just gave tax cuts to the private sector, it would have allocated those resources “efficiently”, because it is the private sector, free markets, bla-bla-bla. Then the govt does exactly that and what? Here is the conservative John Taylor:
http://media.hoover.org/sites/default/files/documents/Where-Did-Stimulus-Go-Commentary-1-2011.pdf
Excuse me? Say again? The was “little if any net stimulus”? What are we talking about here, then?
The stimulus did exactly what it should have done, namely, “the borrowed funds were mainly used by households and state and local governments to reduce their own borrowing”, there just wasn’t enough of it to allow more deleveraging and demand support. This is from a conservative mouth, not from Paul Krugman or MMTers.
Another problem with the stimulus was that there were no plans in place to ” the Hoover Dam, the TVA, parks, roads, bridges the CCC etc.” To have govt works shovel ready for recessions, one needs to have contingent plans in plans. This of course would never be allowed in our free markets orthodoxy! HEre is a great post by Ezra Klein on exactly this problem:
http://feeds.washingtonpost.com/click.phdo?i=0f18521efb423b6e0e2e6ad89cbad4e1
The private sector cannot do moon shots like Rural Electrification in the 1930s or like the Apollo Project of the 1960s. This is what conservatives and liberals fail to understand. Conservatives don’t like government directing capital investment even for moon shots, and liberals think building big things is harmful to the environment and must be stopped at all costs. We live in an industrial democracy that has forgotten what made it great and that has lost its cultural foundation in the fool’s paradise of mindless and directionless easy money. MMT works, but you need a real economy and supply side analysis. “Aggregate demand” takes the real economy 100% for granted.
FDR got many big things right; 1930s moon shots to transform the nation, caging Wall Street and the banks via Glass Steagall and making sure the unemployed didn’t starve while the country tried to dig out of its hole. He was trying to put people to work in an industrial economy; he wasn’t putting them on the dole and justfying idleness under the rubric of sustaining aggregate demand. Obama is a welfare statist who used the GFC as an excuse to expand the dole; he has no vision for this country as an industrial democracy.
Peter,
“That’s really funny, because a lot of people talk of government always misallocating resources when it spends on stuff. I don’t agree, but that’s what you hear most.”
How can one measure if government spending or a tax cut is productive spending versus misallocated? Is it a simple as a GDP multiplier of greater than 1?
If that is the case I would be for replacing our debt ceiling with a spending requirement that the GDP multipler must be >1 for any spending/tax cut.
Ocean, I believe that for a lot of govt spending the multiplier is unquantifiable. Which is fine – govt should spend on things that serve public purpose and those don’t need any tangible ROI attached to them. There is a value for society to allow people to securely retire without the need to eat out of trash cans. Or to allow basic safety by having enough police officers cruising around. Or investing in research that would produce few but very important breakthroughs.
If that is the case I would be for replacing our debt ceiling with a spending requirement that the GDP multipler must be >1 for any spending/tax cut.
A terrible idea, in the light of the above. The public purpose has to be decided by the public thru its representatives, but measures such as multipliers and ROI are simply inapplicable in many cases. In those that they are – no problem, use them, of course.
I tend to believe if we can’t qualify if government spending as productive or misallocated than we are destined to have “control fraud” and misallocation. Actually what will occur is exactly the path that congress is heading down austerity for most and few bailouts and tax breaks that benefit the elites and corporate powers.
One area I’m having trouble accepting is that any government deficit spending is better than productive government deficit spending. (I tend to think MMT is limited by the political process and so is forced to support and settle for “any deficit spending” and what we get is a few bailouts/tax breaks). And thus the reason I think we need some way to qualify if the spending is productive or have some better way to control this (especially is austerity is in the cards).
“…if we can’t qualify if government spending as productive or misallocated…”
I almost agree, except that I would use words like “productive” very carefully or not use at all. As I said before, a lot of govt spending cannot have any precise measure of “productivity” calculated. that doesn’t mean it can or cannot be misallocated. It just means that we the people have to use some other forms of quality control than calculating returns on investment and such. Using measures like “productivity” plays into hands of the pernicious free market idiocy of “govt run like business” (which, by the way, means that for the govt, like a business, to make a profit (surplus) means that the non-govt’s sector takes a loss (deficit), but MMTers know this). We should be intelligent enough to decide that space exploration, for example, could be a worthy goal even if it is a “money sink” while wars are mostly not, even when they bring profits.
Did the S&P break SEC rules on release of ratings to private parties beforehand?
http://www.nakedcapitalism.com/2011/08/did-standard-and-poors-break-sec-regulations-in-disclosing-its-downgrade-to-select-parties.html