In April 2010, Standard & Poor’s warned us that we were on their watch list for a potential downgrade. At that time we wrote an article entitled, “American Exceptionalism and Standard & Poor’s” in which we said:
“America, the world’s greatest country, whose financial strength and dollar were supreme for the past 100 years, has been put on notice by Standard & Poor’s that it is on the road to second-rate status. It was disconcerting to read the ho-hum reactions of economists to S&P’s shift to a negative outlook for U.S. sovereign debt. As one who sees darker implications of a downgrade in Treasurys, it gave me pause to wonder if I am overreacting to the event. Perhaps they are correct in that it will probably not happen, and that if it does, it’s no big deal because the dollar still is the world’s reserve currency. Japan and Great Britain did it and they are fine. And where else would investors go?
“My conclusion is that the other 99 guys are out of step. My fellow analysts are mired so deep in the trees that they overlook the forest of reasons why we got into this mess in the first place. The problem with economic analysis and analysts is that there is a tendency of disassembly. By breaking down the problem into its parts one can miss how they all connect. Perhaps if they stepped back and considered where this country is heading they would be less sanguine.
“After all, we are not looking at a single event but a series of political decisions made over the past 15 years or so that have created today’s budget crisis. And stepping back even further, we are experiencing fundamental changes in American culture. The well-worn cliché of the large ocean tanker taking miles to change course is an accurate depiction of our situation. There is so much built-in momentum based on entitlements and defense spending it is unlikely that a crisis can be avoided.
“Our economic and policy experts need to focus on this long-term problem rather than just its short-term effects. Unless we deal with the fundamental problems, today’s jury-rigged fixes will not stop our continued downward spiral.
• • •
“What does this mean for America and S&P? It means we are likely to experience a downgrade in our sovereign debt at some point in the future. Don’t ask me to predict when this will happen. There are too many ‘what ifs.’”
Nothing has changed since then, and we have consistently insisted that despite the budget deal, we would be downgraded. Friday afternoon, well after the markets closed, S&P announced it was downgrading the United States of America to AA+, one notch below our fabled AAA rating held for 70 years.
In an another column written on July 30, “What Would Happen If U.S. Defaults,” we compiled all the information we could find describing what a default on U.S. sovereign debt would mean. My conclusion on the short-term:
“A somedays of uncertainty, market drops, rates go up 20 to 50 bps, media hysteria, bargain hunting, market surges, Treasurys stabilize, rates moderate after some weeks as money chases Treasurys again.
While our pig may still be prettier than the other pigs, with the U.S. dollar as the reserve currency, we aren’t like Argentina or Japan, and it’s not just a bump in the road. We don’t know the full implications ... yet.
As for the longer-term impact, in the “American Exceptionalism” article we concluded:
“A downgrade means there will be less money available to the government for its programs. It means debt service costs will rise. It means the Treasury will find it more difficult to place U.S. debt. It means that many holders of our debt will try to unload their positions (it won’t be easy for them). It means the Fed will likely acquire more Treasurys, effectively monetizing the debt and this monetary inflation will lead to price inflation. It means the dollar will decline further. It means there will be pressure on the government to raise taxes further. It also means that inflation will be employed as an additional tool of fiscal policy as rising prices (actually devalued dollars) will allow the government to repay debt with cheaper dollars.”
The story behind S&P’s rating call was quite interesting; the agency made a “slight” error:
Around 1:30 p.m. (Friday), S&P officials notified the Treasury Department that they planned to downgrade U.S. debt and presented the government with their findings. Treasury officials noticed a $2 trillion error in S&P’s math that delayed an announcement for several hours. S&P officials decided to move ahead, and after 8 p.m. they made their downgrade official.
As would be expected, the Treasury is now saying: ”A judgment flawed by a $2 trillion error speaks for itself.”
S&P officials acknowledged the error Treasury pointed out but didn’t believe it was so significant. It was a technical error, although it could have serious implications. It concerned the future ratio of U.S. debt to the size of the economy, with S&P officials projecting a larger share than many experts.
— Jeff Harding is a principal of Montecito Realty Investors LLC. A student of economics, he has a strong affinity for free-market economics. This commentary originally appeared on his blog, The Daily Capitalist.