Friday, July 15, 2011

The USA's rating outlook

If the debt limit is raised again and a default avoided, the Aaa rating would likely be confirmed. However, the outlook assigned at that time to the government bond rating would very likely be changed to negative at the conclusion of the review unless substantial and credible agreement is achieved on a budget that includes long-term deficit reduction. To retain a stable outlook, such an agreement should include a deficit trajectory that leads to stabilization and then decline in the ratios of federal government debt to GDP and debt to revenue beginning within the next few years. Moody's does not take a position on what measures should be included in any deficit reduction package. Instead, it is the resultant deficit and debt trajectories that are relevant to the rating and its outlook.
--Moody’s press release on the US rating review (7/13/11)

It would appear that what is most likely to happen is that a ceiling deal will be agreed, the ceiling will be raised and default will be avoided, thus allowing the agencies )or at least Moody's) to retain the AAA on the US, which would be good. However, it is pretty clear that while Moody’s rating will be confirmed at Aaa, the rating outlook will be negative. This because the two other conditions (deficit trajectory and a debt-ceiling permanent fix) are highly unlikely by August 2nd.

However, there is the possibility of an eventual bipartisan deal on the budget. Fixing the debt ceiling permanently will be harder. One idea would be to abolish the debt ceiling in exchange for a balanced budget amendment. This is a very bad idea, because it would create a big crisis the next time the economy has a heart attack. But it doesn’t matter because I don’t think there are the votes.

Another idea (mine), is both easier and better: index the debt ceiling to a fixed percentage of nominal GDP (e.g., the current ratio). This doesn’t require adding a bad and unenforceable amendment to the Constitution, and it should prevent further unending ceiling crises. It’s not perfect (the recession problem), but it can be adjusted at any time by legislation. Or, simply restore Gramm-Rudman-Hollings that required a balanced budget (which means it can be suspended when necessary by legislation). Under GRH the budget was not only balanced, it went into surplus. Remember the looming “Treasury shortage”? Bush and Obama solved that problem.

I certainly hope that both issues can be addressed to Moody’s satisfaction, because they are necessary, and because the US does not need the overhang of a negative rating outlook. The world will be a better place if the US can change its fiscal trajectory and stop having these artificial ceiling crises, and if the Aaa can move back onto more solid ground. The US should be Aaa1 (AAA+), not Aaa3 (AAA-). (When Moody’s started publishing sovereign ratings in 1918, the US bond rating was Aaa*, denoting an even higher category not bestowed on any other country’s.)

I think Ron Paul (who is chair of the House Subcommittee on Domestic Monetary Policy) has now shown himself to be utterly unserious and a truly dangerous person. He wants to abolish the Fed, return to gold AND cause a US default. This would all be fine if he was still publishing his loony newsletter. Just imagine how his plan would play out: no fiat currency, no lender of last resort, and no bond market. 

In fact, we’ve already been there in 1932-33, when the US was on gold, there was no fiat currency, Treasury was running out of cash, the Treasury bond bond market was closed (because the banking system was contracting), and Hoover was forced to cut the budget in the middle of a financial panic. That was not an experiment to be repeated outside of a laboratory.

Thursday, July 14, 2011

The Crime of '11

When the US became a federal republic in 1789, it found itself in a bad spot financially. The Continental Congress had financed the war with paper money, which caused Weimar-style inflation. The paper (“Continental dollars”) was bought up by speculators hoping for redemption in coin. From our nation’s founding until 1933 (Civil War aside), the dollar was pegged to gold at $20 an ounce. Continentals traded for pennies.

Most officials thought that sticking it to the speculators would be necessary and prudent. Hamilton, the Treasury Secretary, was an Anglophile who understood that England had defeated France because it was a good credit and France was not. The Rothschilds bought British bonds; they shuddered at France’s paper (and they made a nice profits whenever the UK won).

Hamilton believed that the US would be like Britain and not like the rest of the world: we would be a sound credit. No defaults.  He redeemed all of the Continentals in gold.

The US has had many credit events since “redemption”: States have defaulted and repudiated their debts; the entire South defaulted and the US repudiated the Confederacy's debts; we issued paper currency during the Civil War (but redeemed it all in gold); we broke the gold clauses in our bonds in 1933 when FDR temporarily took us off gold; and we went off gold entirely in 1971; dollar “Silver Certificates” were with drawn form circulation unredeemed. But the US never ever failed to repay its Treasury bonds on time and in full, if you define “in full” as legal tender and not gold.

So, what was the result? The result was that by mid-20th cenury, the dollar and the Treasury bond became the dominant instruments in the world, the reference for value, the world’s reserve currency (you sell us Toyotas, we give you low-yield paper), and the image of stability and safety. Switzerland with liquid markets.

This is ultimately about brand management (and trust). Warren Buffett said that it takes years to build a reputation and seconds to destroy it. Would Coke put polluted water in its sodas? Would Toyota remove the brake pads from its cars? Would Boeing disable the control surfaces on the Dreamliner? No. But the US, which has built the most important financial brand in world history, the Treasury bond, is about to default. This really takes the cake for stupidity.

We are witnessing is the result of the ideological sorting out of the political parties. In the 1950s, this issue would have been resolved with phone calls from Ike to Speaker Sam Rayburn and Majority Leader LBJ. Rayburn and Johnson were both conservative Texas Democrats, now a forgotten species. The divide between Pelosi and Cantor appears simply unbridgeable. The last time we were in this position was 1861. That didn’t play out well either.
And by the way, default is unconstitutional. If I were the President I would pay my debts no matter what Congress does. Congress can impeach him, but the Senate won't convict. Frankly, I'd impeach him if he didn't override Congress.

The creditworthiness of the United States

Credit belongs only to the most enlightened and best governed nations.
--Daniel Webster

There are a four considerations: (1) will the USA keep its AAA, (2) will it default, (3) what are the possible consequences, and (4) what is the longer-term outlook.

The AAA rating is now on a very short leash: the agencies are saying that the US must agree a deal NOW, and agree a credible debt/GDP trajectory that is consistent with the highest sovereign rating. (These parameters have been published.)

While I could argue that the agencies should leave the AAA alone (because the US is still a very high grade credit), they have no big incentive to treat the USA any different from any other OECD sovereign. So I would expect them to downgrade the US next week or the week after, if no deal is reached. It’s silly to downgrade a bond issuer after it has defaulted. Not much predictive power there!

Additionally, given the CBO’s adjusted medium-term debt trajectory forecast, legislative gridlock (with or without a default) suggests that the US is moving from what I would call Aaa1 to Aaa2, in the direction of Aa1. It’s just simple arithmetic.

However it is important to observe that there are two kinds of countries: those that borrow in their own currency, and those that don't; the latter would be the entire eurozone. Every other OECD country finances itself in the same currency that it prints. (And please don't tell me that euros are domestic currency, except for perhaps Germany).

Printing presses are useful in debt crises. The Fed is the US’s lender of last resort, it has unlimited resources, and a big incentive to help. US default is much less likely than it is for countries that commit the original sin of funding themselves in foreign currency (the eurozone).

Given the digging of trenches on Capitol Hill, the US is at real risk of a technical default which, while it would make the US look like a banana republic run by clowns, would not fundamentally change the country’s underlying credit parameters. Treasuries would still be the best and most liquid bonds in the world. (When Moody’s took Japan to A2 in 1998, it had no impact on JGB yields.)

While a default would be a major dislocation, I don't expect Treasury yields to move dramatically in the event of a temporary default. Institutional investors, banks and central banks will have to scramble to change their investment guidelines. The longer this  standoff lasts, the worse it gets (it becomes less technical and more real). It will be a big blow to confidence, upon which rests the $50 trillion of debt outstanding globally.

The impending Eurozone crisis makes global investors want dollars (and gold, yen and Swiss francs), so I just don't see huge currency/bond dislocations because the temporary default would be technical and not not real. The expected loss of a defaulted US Treasury bond comes very close to zero.

What matters most is not a temporary default, but rather a failure to address the CBO's (adjusted) medium term debt trajectory forecasts. If the Democrats insist on no entitlement reform, and the Republicans insist on no revenue enhancement, the CBO forecasts will materialize, and the the US will face a major crisis in the next decade.

Additionally, as Moody’s points out, when a country defaults and does not adopt reforms to prevent such an event from ever happening again, it doesn’t smell like a AAA, even if the expected loss remains miniscule. Household FICO scores reflect not only repayment but punctuality.

What is happening in Washington today is unworthy of the issuer of the world’s reserve currency.  It is deeply irresponsible. As J.P.Morgan observed, “Collateral is no substitute for character”. Serious countries do not default on their debt due to partisan budget battles. Alexander Hamilton would move to Canada if he were alive today.

Parliamentary democracies do not face this problem. It is a major constitutional problem for the US. (And it is absurd for Congress to appropriate trillions in spending and then deny the Treasury the ability to finance it.)

We don't need anymore shocks. Lehman and the PIIGS are enough. Modern finance is founded on leverage and confidence, and I do not wish to live through a rapid deleveraging of the global economy (1930-34). There is a growing view that modern finance (1980-2011) is a huge Ponzi scheme funded by debt that cannot be repaid without big inflation. I don't subscribe to this view, so long as central banks are prepared to manage the deleveraging without catastrophic deflation (1930-1933).

It is particularly unfortunate that this rodeo in D.C. is occurring at a time when confidence in the eurozone it at an all-time low. National problems can become global problems when they are coincident.