S & P Downgrade: It’s Aftereffects – August 14, 2011

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Soon after the debt ceiling impasse had been resolved, the Standard and Poor rating agency’s downgrade of US debt liability from its triple A rating to AA+ has unsettled stock markets world wide. The gyrations have been compared to a roller coaster but seem to be settling down now. Investor worries in the US were accentuated when the Dow registered a steep decline of 634.76 points or 5.5% ending up at 10809.85. The Wall Street Journal called it the biggest percentage drop since 2008. Not surprisingly, the S&P downgrade – the first in US history – made investors flee to the traditional refuges: gold, safe currencies such as the Swiss franc and US Treasury bonds. TheEconomist opined that “America’s prospects have suddenly darkened.” It predicts that the odds of a double dip recession over the coming year are “uncomfortably high, perhaps as high as 50%.”

However Burton Malkiel, professor emeritus of economics at Princeton in a recent WSJ op ed has cautioned investors to stay the course in reaction to the current market volatility. He stated, inter alia, that “no one has ever become rich by being a long term bear on the fortunes of the United States…this is still the most flexible and innovative economy in the world. Indeed it is in times like this that investors should consider rebalancing their portfolios. If increases in bond prices and decline in equities have produced an asset allocation that is heavier in fixed income that is appropriate, given your time horizon and tolerance for risk, then sell some bonds and buy stocks. Years from now you will be glad you did.” In other words do not join the bear herd. Hold on.

The Economist quoted above also states optimistically that the “US economy still has huge advantages over rich countries: a younger less taxed population, a more productive economy and, for now at least the dollar as the global reserve currency. If only it had the political leaders to match, its chance of avoiding recession would be far better than one in two”.

One aspect of the Chinese reaction to the US downgrade was provided by Guan Jianzhong, Chairman of the Dagong Global credit rating agency. Guan said that the US dollar is “gradually discarded by the world” and the “process is irreversible.” Dagong downgraded the US from A+ to A after policy makers in Washington failed to act in a timely manner to lift its debt ceiling. “They [US] should get a clear understanding that the continuous decline of the debt service capability will inevitably result in the outbreak of a sovereign debt crisis.” He called for a “new, stable and global currency.” As the US’ largest creditor ($1 trillion plus) Beijing has every right “to demand the US to address its structural debt problems and ensure the safety of China’s dollar assets”.

The noted US investor Jim Rogers in an interview to the CNBC stated that the US was unlikely to be able to pay off its debt and the S&P’s rating cut had come too late and should have happened long ago. “It seems to me it’s physically, humanly impossible for the US to pay off its debt.”  Rogers said “They can roll it over and continue to play the charade, but the US is bankrupt.”

According to the S&P the total US public debt which includes local, state and federal government debt will be $11 trillion this year, and will rise to $14 trillion in 2015 and $20 trillion by 2021.

Conclusion

The increase in the debt ceiling has bought time for the beleaguered Obama administration till November when a bipartisan House committee will deliberate on another debt increase. In the event of a deadlock an automatic increase consisting of cuts in defense, Medicare and social security expenditures will be triggered.

Without a long term structural adjustment to the debt leviathan, the US potential to remain the world’s strongest and largest economic power will be seriously and perhaps irreversibly eroded. What is required is a leader like Roosevelt who crafted the New Deal after the Great Depression by bringing different stakeholders on the same page. So far, Obama has failed to show the vision, purpose and resilience of a Roosevelt which the times demand. On the contrary, he is being already being compared, two years and eight months into his presidency, with Jimmy Carter who turned out to be an ineffective and ultimately unsuccessful one term President.

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