Thursday, July 14, 2011

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.

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