Amongst all the debate, analysis and comment surrounding the
tortured attempts of US executive and legislators to agree how to reconcile
their differences and work out how to keep the flow of the nation’s finances
going last week, one small item of news may have slipped under the radar of
many observers. Well, small, but with possibly quite significant implications.
The Dagong Credit Rating Agency, one of the four principal Chinese agencies,
downgraded the United States
from A to A-. Now, for those who like to indulge in a little schadenfreude,
that puts the US below, for example, the UK, Belgium and, yes, mighty Botswana.
Before dismissing this with a wave of traditional western feelings of
superiority, it is worth taking a look at the well-argued reasoning behind
Difficult to Contest the Arguments
First, they point out that the shut-down of the Government
spending which lasted for - roughly –
the first two weeks of October, is a reflection of a shortage of liquidity
caused by the retirement of old debt without a concomitant increase in new
debt. Between 2008 and 2012, the ratio of the government’s stock of debt to its
fiscal income moved from 4.0 to 6.6. That clearly imposes a strain on the US government’s
ability to pay its normal expenses, and reflects a genuine decrease in its
actual solvency. In other words, if you've run you borrowings up to the limit
and you don’t generate enough income to pay your expenses, something has to
give – hence the shut-down.
Secondly, since the financial crisis of 2008 erupted, the
gap between the stock of debt and the country’s wealth creation has grown
markedly. Between 2008 and 2012 the stock of debt increased by 60.7% while at
the same time nominal GDP increased by 8.5% and fiscal income (effectively, tax
take) actually decreased by 2.9%. You don’t have to be an economic genius to
work out that that’s not good; if the relationship between the increase in your
debt, the growth rate of your economy and your tax receipts is like that, then
the only conclusion one can draw is that the debt cliff will be a threat for a
very long time. In other words, things don’t appear to be getting any better.
Thirdly, the contentious policy of quantitative easing has
caused liquidity to be injected continuously over the period into the economy.
The dominant position of the US Dollar as a reserve currency has enabled the US,
effectively, to an extent to monetize its debt at the expense of the
international holders of that debt. In other words, if you devalue your debt
through QE, that looks good for you, but at the same time you devalue what your
creditors are holding – and there will come a point where they will no longer
sit back and watch that happen. The debt will become more difficult to sell, as
international holders look for a safer asset. The estimate of the effective
‘cost’ to the holders of US
debt between 2008 and 2012 is US$628.5bn. The caveat I must make here is that I
have no way of judging the accuracy of that figure, but it doesn’t appear to be
Fourthly, the US Government, broadly, has no alternative to
try and squeeze out of the hole it is in but to continually raise the debt
ceiling, which is precisely what they have been doing. Unfortunately, that
simply exacerbates the problem, because adding more debt when already the
growth of income does not match the growth of debt is almost bound to lead to
the problem getting worse and worse. The posited solution is in fact no
solution at all.
Fifthly, the US
politicians seem incapable of co-operating for long enough to begin to make
some steps towards a rational solution, which frankly calls into question the
solvency of the US Government.
That’s a summary of the logic Dagong have applied to their
assessment of the current state of the US and the rationale behind their
downgrade. I can’t pick too many holes in it.
Others may Follow?
Dagong are not the only ones, of course. Fitch are strongly
rumoured to be looking at a downgrade (after putting the US on negative
watch a while back), and the implications of this are potentially quite
significant. The biggest holder of US
debt these days is China,
and downgrades, particularly coming from a Chinese agency, will cause waves. If
Fitch follow, it will make more than waves; if the security level of US debt
drops below that preferred by international buyers – and think particularly
central banks here - then our picture of the world will change dramatically.
The best guess is probably to expect more buyers chasing gold, since it’s
difficult to make too much of a case for the sovereign debt of other states – a
weakening of US creditworthiness will mean a relative strengthening for
Euro, Sterling, Yen et al debt, but surely the ultimate triple-A asset of gold
would see the greatest reweighting of asset allocation?
Politicians miss the Target
Now, there will be those who point out that the Chinese (and
all the rest of us) have a vested interest in the security of the US, and there
is of course a great deal of truth in that. I’m not for a moment suggesting
imminent collapse and ruination; what I am saying is that the US problem is not
eased by the actions taken by its politicians, and indeed the very
short-termism that they are indulging in (all seeking electoral advantage) is
making the problem worse and strengthening the logic behind Dagong’s
assessment. Small ripples can spread a very long way and ultimately become
frighteningly big waves.