Yes, I know I dissed the S&P report as fundamentally wrongheaded, but as we will discuss shortly, it contained some interesting commentary on the US financial sector that has gotten perilously little notice.
But I’d first like to address the way the media and some blogosphere commentators have hopelessly muddied the issues on the downgrade scaremongering. One is the “we depend on foreigners to fund our budget deficit” hogwash. As Michael Pettis pointed out, the idea that the US is funding its federal deficit from foreigners is a widespread misconstruction. The reason we have capital inflows, largely but not entirely foreign purchases of Treasuries, is that we are running a current account deficit. As long as our trade partners want to run surpluses with us, they wind up holding dollars. They could just keep them as cash, but most seem to prefer to get some income, and Treasuries are a popular choice because they are liquid.
If they want to quit accumulating dollars, they have to stop running surpluses with us. Despite all the brave talk of rebalancing, no one seems very keen to do that right now. Most countries except the US seem to like the idea of having high domestic employment rates by virtue of selling goods to the US.
So if they decided they wanted to quit accumulating dollars, what happens? If the US trade deficit went into balance, we’d replace the goods we bought from abroad with domestic production. That means a higher domestic employment rate since we are no longer “leaking demand” abroad. That means a higher growth rate and higher tax receipts. Both of those would improve out debt to GDP ratio. (Pettis provides a longer form discussion with more scenarios, but this is the drift of the gist).
The second misconstruction is acting as if GDP were static and impervious to budgetary changes, and therefore the way to deal with large debt levels is to cut spending. Unfortunately, empirical evidence solidly refutes this idea. The UK tried that 10 times in the last 100 years, and every time the debt to GDP ratio got worse. We are seeing the same results in Ireland and Latvia. In Japan, when the government got nervous about spending in 1997 and reduced expenditures, the debt ratio worsened.
Conversely, when an economy is slack (and that is the critical caveat), well targeted spending (and that does NOT mean tax cuts to the rich, who put too much of their excess dough in secondary securities markets) produces GDP increases such that the debt ratios do not worsen, indeed, they typically improve. The trick is, like steering a car into a skid, when to judge when you’ve reached the point that you can begin to change course. That’s one reason why automatic stabilizers, like unemployment insurance and food stamps, are so useful: not only do they target people in need and therefore likely to spend, but those expenditures fall off naturally when the economy improves. They don’t need to rely on Congresscritters to exercise discipline; the programs are structured to pay out less in a strong economy.
Now to the interesting and not widely noticed part of the S&P commentary. Even though we are pretty skeptical of the rating agency’s analysis, remember that they tend to be followers rather than leaders (as in they often issue corporate downgrades after spreads have widened). Thus a view like this is noteworthy (hat tip reader Lynn F; boldface ours):
Additional fiscal risks we see for the U.S. include the potential for further extraordinary official assistance to large players in the U.S. financial or other sectors, along with outlays related to various federal credit programs. We estimate that it could cost the U.S. government as much as 3.5% of GDP to appropriately capitalize and relaunch Fannie Mae and Freddie Mac, two financial institutions now under federal control, in addition to the 1% of GDP already invested (see “U.S. Government Cost To Resolve And Relaunch Fannie Mae And Freddie Mac Could Approach $700 Billion,” Nov. 4, 2010, RatingsDirect). The potential for losses on federal direct and guaranteed loans (such as student loans) is another material fiscal risk, in our view. Most importantly, we believe the risks from the U.S. financial sector are higher than we considered them to be before 2008, as our downward revisions of our Banking Industry Country Risk Assessment (BICRA) on the U.S. to Group 3 from Group 2 in December 2009 and to Group 2 from Group 1 in December 2008 reflect (see “Banking Industry Country Risk Assessments,” March 8, 2011, and ” Banking Industry Country Risk Assessment: United States of America,” Feb. 1, 2010, both on RatingsDirect). In line with these views, we now estimate the maximum aggregate, up-front fiscal cost to the U.S. government of resolving potential financial sector asset impairment in a stress scenario at 34% of GDP compared with our estimate of 26% in 2007.
In other words, S&P disputes the idea that extend and pretend is working, and sees that financial sector risks are rising. Put it another way: if the rating agencies can no longer support the official cheerleading, how much longer will anyone regard it as credible?
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well, don’t forget the rating agencies defence in the hearings on the financial crisis, that the ratings they publish are only opinions, with first amendment defence…
looking for control fraud, the 3 rating agencies should be main culprits, because without their sign of approval in the form of AAA rating, the structured paper wall street created from subprime mortgages, could not be sold to any pension funds across the world. its amazing that this guys didn’t got lawsuits from the investors who bought this crap
on the other side, maybe if the american government pay a large sum to the rating agencies like wall street banks, maybe they will publish a new “opinion” that the US is best, and give the treasuries AAAA ratings….
dear yves,
i have some things to share with you. most of them are about the financial crisis ( about pepole who understood the crisis long before it broke ) and one that will help with “academic choice theory”. because i could not find your mail, and i am required like everyone to put my email to leave a reply, i guess you have mine, so be in touch.
Japan has been able to take on more debt because no one one saves like the Japanese, so they have had more assets per capita to borrow against. We on the other hand are spenders, and that can get us on the path to growth faster whether that spending comes from the public or private sector. Borrowing to spend however is kind of a problem because so much of our savings are tied up with real estate. Looks from the information above that our Fannie and Freddie hole is in the neighborhood of 1 trillion, and there is an additional aggregate of bad assets around 5 trillion. Sounds about right. That is a pretty deep pit. Then there is also our accumulated public debt. Growth is the way out of all this, and we can theoretically work with our way back with more deficit spending for at least some more years, especially if we can rebalance our current account deficit with the Chinese with foreign exchange pressure. But has all of the Fed easing and infusions made a dent in that 6 trillion hole of bad assets at the banks. Based on the note above, maybe not enough. The national debt then becomes a bigger impediment to our strategies for growth. Would be good to hear Bernanke’s assessment on the current overhang of bad assets in our financial markets.
Agreed that we are taking exactly the wrong approach, coddling the banks and not doing enough to fix the real economy.
The Japanese had very high savings, but the estimates I’ve seen is that their toxic asset problem was also vastly worse than ours. Hard to get decent data, but just consider the magnitude of their joint real estate/stock market bubbles relative to the size of their economy. And banks would lend 100% against the value of urban land pre-crisis, when it never traded. Never never never. Taxes were confiscatory and selling your land would be an admission you were bankrupt. It was the biggest phony market ever.
Yes, the over speculation in real estate and stocks killed them when their bubble burst, and most of their banks held on to their bad loans against these ghost assets forever without writing them down. But it was in part their citizens who had all that money saved in their postal savings accounts (huge sums in aggregate) and other hard assets that allowed the banks to keep borrowing. The huge appreciation of the yen following the Plaza Accord in the 80s also probably helped. Today they are at the bottom of the barrel with most of those savings. The yen should be weaker, but the Chinese among others keep it propped up, just as they do to some degree with the dollar. China needs to let the yuan appreciate naturally. It would be healthy for everyone including the overheating Chinese economy at this point.
“most of their banks held on to their bad loans against these ghost assets forever without writing them down.”
“Their banks” applies to the US as well as to Japan.
“the estimates I’ve seen is that their toxic asset problem was also vastly worse than ours.”
*******
And then they suffered a nuclear meltdown. Holy hell what next, Godzilla vs Mothra through the streets of downtown Tokyo??
When were these 10 times in the last 100 years that the UK tried to reduce debt and failed? I must admit I’m struggling to work out when these were.
I have a print version of a paper that lays it out in sordid detail, I need to locate it again, since print thingies go missing easily. If I can get a pdf, I’ll upload it. It also goes through budget cuts and says sometimes they lower debt to GDP, sometimes they make it worse. Seems to depend on whether businesses were investing or not. If so, you got crowding out and bad results, if not, it is salutary.
Yves,
You may have something better amongst your print thingies, but this is a pretty good Chick and Pettifor paper from last year that covers the relevant territory:
http://www.primeeconomics.org/wp-content/uploads/2011/02/The_Economic_Consequences_of_Mr_Osborne.pdf
I’ve been looking in vain for a similar look at the US. Someday I’ll figure out how to convert the data into tables myself, but a chart that showed in constant dollars the annual budget deficit, the accumulated debt, the growth rate and total GDP year on year would tell an interesting story.
interesting but the authors seem to have cherry picked rather peculiar and inconsistent time periods (Table 2.1) during which to measure changes in Gov Expendure vs. changes in Debt/% GDP. For example, how is the period 1976-2009 at all informative or interesting given that it covers a number of very different governments with very different economic policies? I’m not sure this analysis would stand up to any detailed scrutiny at all.
Beautifully written, the official cheerleading does get tiring after 3 yrs or more. It’s going to be interesting with extend and pretend seeming to be coming to an end just as the 2012 election cycle heats up. Your points are so well taken that the emphasis now should be on the real economy. The Geithner/Bernanke cover-up didn’t work. The time seems right to call out the fraud and start the work to repair the bottom 99%.
http://www.ft.com/cms/s/0/cac38a7c-e5da-11df-af15-00144feabdc0,dwp_uuid=562a9148-1e5a-11e0-bab6-00144feab49a.html#axzz1K4oBObgf
Foreclosure crisis is a sitting duck for politicians
By Francesco Guerrera
November 1 2010
In football, there is no greater sin for an attacker than missing a “sitter”: an easy opportunity to score, usually with the goal wide open. But when it comes to the foreclosure crisis plaguing the US financial sector, there is no better way of putting it: the politicians are missing a sitter
The Chinese credit agency downgraded US bonds from AA to A+ in November, 2010. The FT reported on this and here’s what they said (http://on.ft.com/ie9Gea):
1. The serious defects in the United States economic development and management model will lead to the long-term recession of its national economy, fundamentally lowering the national solvency.
2. The new round of quantitative easing monetary policy adopted by the Federal Reserve has brought about an obvious trend of depreciation of the U.S. dollar, and the continuation and deepening of credit crisis in the U.S. Such a move entirely encroaches on the interests of the creditors, indicating the decline of the U.S. government’s intention of debt repayment.
3. Analysis shows that the crisis confronting the U.S. cannot be ultimately resolved through currency depreciation. On the contrary, it is likely that an overall crisis might be triggered by the U.S. government’s policy to continuously depreciate the U.S. dollar against the will of creditor
Despite the downgrade, China continued to purchases US treasuries. The only change was a higher reliance on proxoies in the UK. Apparently, we had to wait to call them hipocrites until reconcilliation was done.
China and the West – a couple of sexomniacs who can’t help themselves.
Don’t cry for China.
They are getting something for their money. Like oil contracts in Iraq and mineral contracts in Afghanistan.
I have a question. I’m an economics ignoramus so forgive me if I’m wasting your time but you say above: “…we’d replace the goods we bought from abroad with domestic production.”
Is that necessarily true? What if your economy just does without or with less?
Less is more.
It’s a good way to make sure ‘green people’ don’t have the ulteriro motive of trying to make money selling ‘green products,’ but really trying to save the planet.
Go green, just don’t buy whenever you can, period.
Forget being the first on the block to get an electric car. Just get a horse. You won’t be the first. In fact, you will be 100 years behind. And yet, a horse is an biodegradble import-independent transport machine.
well if we buy less from ourselves (if we stopped buying from others) that would mean we would have even fewer jobs. since every one is selling to some one else. and if they stop buying, your jobs goes away. is that really what you want?
http://www.wto.org/english/thewto_e/whatis_e/tif_e/doha1_e.htm
Here’s where your analysis fails:
“If the US trade deficit went into balance, we’d replace the goods we bought from abroad with domestic production.”
Really? Let’s just look at oil, as an easy example. There’s no way we could replace imported oil with domestic production. We’re going to be seeing what oil prices over a $100/barrel do to the US economy now. Imagine if the dollar halves again in value.
This warning probably has something to do with the US debt ceiling that has to be raised. Someone at the TV news said it would be “immoral” to default on the debts due to debt ceiling. But it would be a fraud to keep borrowing already knowing not able to pay it back. US debt at $14 trillion has to be recycled every year about 1/6 of that, besides the burden to ongoing balloon deficit. Charge up additional $4 trillion for two more years and go bankrupt? that sounds irresponsible as the world reserve currency printer.
probably has more to do with the threat to not rise the debt limit. cause that means its would be possible that government spending would all stop. and while we keep cutting taxes, which is lowering tax revenue, and not getting any thing from it. we had so many promises that tax cut or that tax cut would increase jobs. and so far it hasn’t happened. after almost a decade now
‘Scaremongering … is the “we depend on foreigners to fund our budget deficit” hogwash.’
This statement is a distortion of what Michael Pettis wrote. He’s looking at the accounting from the foreign point of view. If foreigners choose to run trade surpluses with the U.S., then of course they will accumulate dollar-denominated claims, which amount to financing the U.S. current account deficit.
Similarly, the U.S. chooses to use (I would say ‘ABUSE’) its reserve currency privilege to run current account deficits, which amounts to accepting vendor financing from foreigners.
Regardless of which party is the initiator, or whether it’s just an unhealthy, mutually-dependent symbiosis, empirically current account deficits and fiscal deficits closely track each other, as this chart from buoyanteconomies.com demonstrates:
Chart: http://www.buoyanteconomies.com/CAD_Fo1.gif
Source: http://www.buoyanteconomies.com/CAD_Formula.htm
Setting aside the semantic distinction between current account and fiscal deficits — which turns out not to be that significant in practice — the U.S. is accumulating an unhealthy amount of foreign indebtedness.
Few economists ever question how the Federal Reserve’s custody account — one of the principal repositories of these burgeoning foreign claims — could more than quadruple in the last eight years. That’s a compound annual growth rate of 20 percent. How can such runaway growth of financial claims be consistent with financial stability? Common sense tells you that it can’t.
The vital custody account has morphed into a magic beanstalk, growing to the sky along with gold, silver and crude oil prices. Someday this unsustainable growth will print a ‘spike top’ … like the last one in July 2008. (Thus S&P’s dire warnings about the continuing unsoundness of the U.S. banking system.)
As far as I know, the Fed’s $3.35 trillion custody account is the largest deposit account on the planet. Is it possible for such an account to experience a run of official redemptions? I say that it certainly is possible. And that it is insanely dangerous for the Fed to allow this account, which was never intended to be anything more than a convenient temporary buffer for clearing, to metastasize into a ‘too big to fail’ sword of Damocles hanging over our fool heads.
Indict Bernanke for his financial crimes …
With trade, one country will run a surplus and another one deficit.
With taxation, one state will get back more than it sends to Washington DC and another will get less. You have read this before.
Again with taxation, one taxpayer will get back more (in his/her share of national defense, paved roads, etc) than he or she pays and another will get less.
With Medicare/Social Security, one generation will get back more than it pays in and another genaration will get less.
The inequalities will always exist but will go away when these activities/programs stop.
Jim,
Did you read the Pettis piece I linked to? Apparently not, and it’s from April 16. He says PRECISELY what I said he says, just less pointedly, and specifically disagrees with Martin Feldstein’s deficit scaremongering. I did not misrepresent Pettis.
In addition, the Chinese are not going to sell those US $ assets. It would send their currency to the moon, which is the last thing they want. Those dollar holdings are not an investment, they are an economic dead weight. Pegging the currency was a means to get around WTO rules and that is what led to the dollar pileup. If they had has export subsidies and tariffs they would have achieved the same end but without accumulating dollars. The dollar accumulation is a by product of their regulatory arbitrage, and has now become so large that it’s an issue politically. If they have gone the tariffs/subsidies route, they would have incurred costs and benefits on a current basis and not shown the accumulation.
Yves,
I don’t disagree with you that the Chinese, through their FX policies, are increasing their dollar holdings. What I disagree with is what they do with it. There is a reason why commodity prices across the board are higher in USD terms. The main reason is that reserve holders, like the Chinese, are moving away from the USD into hard assets, be it commodities, or commodity production. One way to see how much is to track the actual increase in bond holdings from the Chinese. You would see that the increases is nowhere near the level of change in their reserves. Of course this means that this stock of USD has become SEP (Someone else’s problem).
And another thing to note is the impact of capital flow out of the country via coupon payments. You have mentioned that the Japanese have extremely high debt funded by domestic savings. What you fail to mention that any interest payment is recycled internally within the country. When the debt is external, these payments are leaked out and represent a capital outflow, which has to be funded, either via trade surpluses (not the US) or via increased borrowings from the external market, or via monetisation.
As for the funding of US debt issuance, the Treasury WILL need to find new buyers for their debt if the Fed ceases its monetisation activity. And it will have to come from other asset markets (like equities). Its called crowding out.
Yves, great summary of the most relevant economic issues from paragraphs 2-6. It shows to me how just a good summary of what we already know makes a stronger argument than piecemeal arguments. I think you could write a great OP-ED column for the NYTimes from paragraphs 2-6, and it would be one of the best columns in a long while.
btw, why doesn’t my normal email work to post comments here? Is it because I pointed out weaknesses in the guest posts about the Dai-ichi nuclear situation?
No, it’s because I don’t like you putting your URL in comments. It amounts to link whoring and I can’t suppress that feature in WordPress. On some past posts (not recently) you made a LOT of comments, some not much value added, and it looked like an effort to embed links here.
Hey, its your site, and you can do whatever you want, but I think it adds value for comments to argue points in a civil manner and/or confirm someone’s points. I don’t think agreeing in some manner with the OP is the only ‘value added’.
But if you mean just comments like: “Good point.” then I think you should reconsider. If there is more discussion and fewer unanswered comments, then your site will get more traffic over time since more people will feel they can get discussion (instead of being unanswered). My comments tend to be friendly because that’s my style.
I think traffic for econ blogs is down because of crisis fatique and having several of the most prominent issues of the financial crisis addressed well by now. As the crisis ages, there is less interest. You don’t lose traffic because you have competition. If another blog has a very good post on a topic, it tends to increase the appetite for more on that topic. Your seeming competitors help create more readers over time. The decrease lately is only about the natural flow of public interest in issues — the financial crisis is getting old to all but the people truly interested in economics or politics probably.
Finally, I like discussion, and always hope I’ll get into a back and forth, so that’s why I will sometimes make a lot of comments. Many readers will go where they can find back and forth. I think the number of readers only wanting to read without discussing is less every year.
My opinion of S&P’s warning was they just took a page out of Meredith Whitney’s playbook on municipal bonds, only they didn’t go on 60 minutes.
“if the rating agencies can no longer support the official cheerleading, how much longer will anyone regard it as credible?”
****
Wouldn’t that depend on whether or not S&P’s recent call proved to be correct – as told only by future events?
Time will tell. Maybe only a year from now, maybe as much as ten. I’ve given up financial prognostications for lent.
But S&P may be more right than wrong on this.
We’ll see and good luck to all.
Oh and Eve,
Regarding your last sentence:
“if the rating agencies can no longer support the official cheerleading, how much longer will anyone regard it as credible?”
Which party does the word ‘it’ refer to in this statement? Please clarify this for me.
Thanks
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ping
It’s just one big game of chicken. Who will blink first. An epic battle over currency valuations and fair trade. Here, hold our currency, we will make sure you lose your shirt sucker. China needs to open markets and spur domestic demand. The U.S. is still the biggest guerrilla in the room.
Great stuff Yves. The build up was very relevant, regarding the importance of counter-cyclical stim and the futility of pro-cyclical austerity, and the great “money quote” that I did not know about. I’m surprise you beat Simon Johnson to it on his own issue! :)
Quick suggestion.
This could be part of a “bold quote” as well, especially the % numbers.
“up-front fiscal cost to the U.S. government of resolving potential financial sector asset impairment in a stress scenario at 34% of GDP compared with our estimate of 26% in 2007”
to put in perspective, 34% pf GDP would be almost a 50% increase in the total “debt held by public”. Preventing something like this should be an absolute no-brainer for anyone who ostensibly cares about the debt
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