www.lexisnexis.ca Vol. 30, No. 11 Mid-September 2014
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Downgrade latest body blow for an America on the ropes Print This Article
By Jeff Buckstein


Mid-September 2011 issue


Serge Pepin of BMO Investments stands in front of the Toronto Stock Exchange. Markets fluctuated wildly in the wake of Standard & Poor’s decision to downgrade the credit rating of the United States one notch as political infighting prevailed among America’s leaders.

In spite of a last-minute deal between the White House and Congress to raise the $14.3 trillion debt ceiling in the United States by at least $2.1 trillion, credit rating agency Standard & Poor’s downgraded the world’s most powerful economy. That controversial move sparked another round of wild stock market gyrations and speculation about deeper financial downturns going forward. It all occurred against a backdrop of bitter partisan argument and finger-pointing that highlighted the inability of America’s political leaders to forge consensus on a long-term exit strategy aimed at moving the country out from under its mountain of debt and economic gridlock.

Standard & Poor’s took the unprecedented step of reducing the U.S. long-term sovereign credit rating from a perfect AAA rating to AA+, placing the U.S. on the same plateau as the small economies of Belgium and New Zealand.

"The deal struck between the White House and Congress over the debt ceiling alleviated some fears and concerns in the market. But the political bickering hurt the financial reputation of the U.S." says Serge Pepin, head of investments at BMO Investments Inc. in Toronto.

Standard & Poor’s was critical of the role political gridlock played in delaying what it viewed as much-needed action on the federal debt level.

"The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than we previously believed," charged the S&P report detailing its downgrade decision. "The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge."

Mark Waldman, executive-in-residence in the department of finance and real estate at American University in Washington, D.C., likens the U.S. credit downgrade to "a shot across the bow," and slams all politicians, regardless of affiliation, for their performance.

"Didn’t all those folks look like a bunch of three-year-olds? There wasn’t an adult in the room? They were just scoring points trying to prove the other guy wrong. The S&P looked at that process and said, we’re never going to get out of our problem if we keep dealing with it this way," he says.

Standard & Poor’s also made clear they didn’t believe the U.S. was trimming enough from its budget deficit in the agreement, which involved an immediate $917 billion cut, plus up to another $1.5 billion in savings to be recommended by a bi-partisan 12-member Congressional committee, which is due to report by November.

"The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics," their report stated.

"The S&P mentioned prior to the debt ceiling deal they wanted to see cuts in spending and/or increased revenue of some $4 trillion over 10 years. There were only cuts in spending of up to $2.4 trillion over 10 years, which is one reason why the S&P reacted as they did after the deal was struck," says Pepin.

To make matters worse for the U.S., S&P kept the country on a negative credit watch and threatened to further lower its long-term rating to AA within the next two years if there is less reduction in spending than initially agreed to; or if other factors such as higher interest rates or new fiscal pressures emerge that put additional pressure on the government debt trajectory.

Sherry Cooper, executive vice-president and chief economist at BMO Financial Group in Toronto, blasts the S&P move to lower the U.S. credit rating as "nonsense. The fact they reaffirmed France’s AAA and put the U.S. on not only AA+ but with a negative watch is strictly political. France has a parliamentary system, so it’s easier for the president to push through policy, whereas in the United States, it’s always a bit messy," notes Cooper.

"The U.S. issues are, in many ways, manufactured. The U.S. economy is slower than what most forecasters, including the Federal Reserve, had believed, and this weakness in demand in the U.S. is, in my view, the real issue — not the debt ceiling, or the so-called debt crisis," she stresses.

The two other major credit rating agencies, Moody’s and Fitch, retained their AAA rating for U.S. sovereign debt.

Financial markets around the world responded with extreme volatility in the days immediately following the S&P decision, reflecting fears about the debt situation in both the U.S. and Europe at a time when economies are cooling.

In Europe, one major fear is contagion. Investors and analysts worry that the crisis currently engulfing heavily indebted Greece — which recently received (their second) 110 billion euro (about $150 billion) injection from fellow Eurozone members and the International Monetary Fund — as well as a debt-laden Portugal and Ireland, which also received earlier bailouts, will spread to larger economies like Italy and Spain that also have high levels of debt.

"The problem we’re running into, and where the markets really seem to have keyed into lately is this whole idea that one meeting, one program, or one wave of the magic wand is not going to solve all the world’s problems in one shot. This is a long process that could drag on for years to straighten out because it took countries decades to get into this mess," explains Colin Cieszynski, a market analyst with CMC Markets in Toronto.

Cooper believes European debt presents a greater threat to global financial stability than the U.S. does, in part because of the very different context in which the Eurozone functions. There, 17 countries operate within a monetary union, but lack a fiscal union with a single government capable of determining policy, she explains.

Moreover, Cooper points out, the European Union has expressed reluctance to transfer capital from its richer countries to poorer members. A federal government of Europe would have the authority to issue euro bonds that would allow a risk swap, whereby the weaker country risk could be swapped to borrow against some of the strength of the stronger countries. But that, too, has met with resistance, she says.

"If the European monetary union is to be sustained, individual countries have to decide they will take on the responsibility to broaden the borrowing power of the European bailout fund … allowing it to borrow and issue euro bonds, and use the proceeds to support the bond markets of all the different countries in Europe. That means Germany and other rich countries (will) bear a disproportionate burden," Cooper says.

"It is affordable if they want it badly enough. But how much do they really want it? The Germans in particular don’t want to lose control of their own economy. They have been advantaged tremendously by the European Union because the (euro) is much weaker than the deutschmark. Germany has benefited from a huge trade surplus to the rest of Europe," she adds.

There are also significant, growing concerns that another credit crunch — similar to what happened in 2008 when banks became reluctant to lend to one another, and to the public — could be lurking. Experts note that some European banks, even those located in relatively healthier economies, hold varying degrees of sovereign debt in the countries that are most at risk.

"In 2008, the attack, so to speak, by some investors was against the large investment and commercial banks that were exposed. It was a contagion. Bear Stearns went down to a merger, Lehman Brothers next fell to bankruptcy, then Merrill Lynch was sold," recalls Robert Ascah, director of the Institute for Public Economics at the University of Alberta in Edmonton.

Ascah draws a parallel to today’s situation, except now it is government finances that are in trouble, with weaker countries like Greece, Portugal and Ireland being propped up by bailouts, he points out.

In order to get the U.S. economy on a solid economic footing again, "I think Americans have to face the music," stresses Ascah. "Higher taxes are one route to this solution. The other, very challenging route is how to gradually pull back on some of the entitlement programs (like) social security. They have to deal with the defence budget. It tends to be sacrosanct, but they’re spending $700 billion a year on defence, and can’t afford to do that anymore," he says.

Among other actions, the U.S. also needs to study ways to more efficiently operate its government-run Medicare system; and consider the possible elimination of subsidies they can no longer afford, such as to farmers, argues Ascah.

Waldman believes a legislated solution is the only answer.

"I have come to the belief, reluctantly, that a balanced budget constitutional amendment is the only thing that will work. Everything has to be on budget, and the only exclusion would be for a war declared by Congress. It’s a Draconian solution, but given the other incentives for elected officials I think it’s the only thing that will work," he says.

The U.S. Federal Reserve recently announced it intended to keep the federal funds rate at a rock-bottom range of zero to one quarter of one per cent until at least mid-2013 if the U.S. economy doesn’t pick up. The Fed did not announce a third round of quantitative easing — a measure that involves purchasing government bonds to increase the money supply and lower borrowing costs for individuals and businesses — as some had forecast in response to what appears to be a cooling economy.

However, by publicly announcing the intention to keep short-term rates exceptionally low for another two years, the Fed managed to push long-term interest rates down, which is in effect what a third round of quantitative easing would have done, explains Cooper, who doesn’t believe the U.S. or global economy is currently looking at another recession.

"I don’t believe we’re going to see another double dip. That’s not to say it’s not possible, but I believe that there are still equilibrating forces out there. The U.S., for example, is benefiting from a weak currency. Some of the factors that contributed to the slowdown in the first half of the year are reversing, like the decline in food and energy prices. The disruptions from Japan have dissipated."

Cooper acknowledges the existence of a number of negatives. Some economists say we are seeing major structural changes requiring deleveraging that might happen only every 75 years or so. That view may have some merit, Cooper says. "I think when you combine the demographics with what has happened in terms of wealth and the need for further prudence in financial management, you do get this effect. I mean, the boomers are no longer having babies and buying ever bigger homes," and they are "now right up against saving for retirement. That kind of aging population is a fundamental in all the developed economies," she says.

There may be one silver lining in all of this market turmoil, says Cieszynski. "One of the things the market has done that’s useful is putting politicians’ feet to the fire, and forcing them to have to start making the difficult decisions they’ve been trying to put off forever," he says.

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