The clock is ticking. The US economy is tied to the railroad tracks, the train is due to arrive Tuesday 2nd August. The rescuers are dithering, arguing about tax hikes and entitlement cuts. An agreement was expected last week; now the unthinkable has become imaginable. A senate vote is scheduled for Sunday afternoon but the United States congress may well be too fractured and self-important to raise the debt ceiling in time. If they fail, how will this melodrama end?
With a whimper. The executive branch retains options should the legislature continue to be intransigent. If George W. Bush could find lawyers to legitimate torture and unprovoked war, it shouldn’t be too hard for Obama to find some that will allow him to save the economy from self-inflicted disaster. Lawyers have already constructed a variety of arguments allowing Obama to ignore Congress’s inability to raise the debt ceiling, ranging from his obligation to comply with the budget congress itself passed this year to an obscure clause in the constitution insisting that US government debts are inviolate and cannot be defaulted on by act of congress.
Other proposals include selling the Federal Reserve an option to buy government property for $2 trillion (which the Fed will allow to expire harmlessly), using that newly printed money to pay upcoming bills. The next US government bond matures on 15th August, plenty of time for a programme to be cobbled together that avoids default. So far, Obama has been timid about imposing unilateral solutions, but maybe the dangers of failure combined with the idiocy of Republican intransigence will give him courage. Let us hope.
But the debt ceiling is not America’s only self-inflicted wound. Much more likely is a downgrading of US government debt. The financial services company Standard and Poor’s, worried about budget deficits, is threatening to take away the government’s AAA rating, which many fear would raise interest rates on T-bills, thereby increasing the deficit, and slowing the economy further by raising borrowing costs throughout the economy.
Rating agencies were vital enablers during the bubble, certifying that securities constructed out of NINJA mortgages were almost risk-free. Proclaiming dubious debt as AAA, the rating agencies allowed pension fund managers and German bank executives to gain higher yield without seemingly raising their risk profile. Their bond portfolio remained AAA, but they managed to squeeze a few more basis points and so goosed their bonuses. Of course, we have discovered those mortgage-backed securities were not risk free and their purchasers have lost a bundle. The rating agencies have been accused of incompetence, over-optimism and actual corruption.
They are now trying to redeem their reputations by tilting in the other direction, allowing them to be as damaging to the economy on the way down as they were on the way up. How worried should we be? Perhaps not too much. For one thing, most investors don’t need the ratings agencies to tell them the deficit is increasing. They do their own research. For another, investors continue to view US debt as the safest possible, the risk free asset to which all other securities are compared. That is because of the depth and liquidity of the US bond market, making it the easiest market to get in and out of. That will not change, even if it loses its AAA rating. After all, there aren’t enough Swiss Franc denominated bonds to satisfy the market. If Treasury bonds are downgraded, AA will just become the new AAA.
Back in 2006, when Nouriel Roubini and other Cassandras were predicting disaster, their most likely scenario was a decrease in the appetite for US debt and a fall in the dollar. In truth, the crisis went the other way. Yields on US government debt have fallen to unheard of levels. A lowering of risk tolerance has made investors crave T-bills, despite the rising deficit. According to Brad Delong and other economists, our problem today is a shortage of “risk-free assets.” No matter what Standard and Poor’s says, no matter the deficit, investors seem insatiable in their desire to buy treasuries. Republicans can fume and rating agencies can fulminate but markets don’t seem worried. On Friday, the yield on the ten-year bond actually fell.
Don't worry, be happy
July 31, 2011
