S&P Is Too Optimistic

From: Asia Times Online

The good news from Standard & Poor's was that the company reaffirmed the United States' "AAA" sovereign debt rating. The bad news was that its outlook was revised to "negative".

From Standard & Poor's: "We believe there is a material risk that US policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation does not begin by then, this would in our view render the US fiscal profile meaningfully weaker than that of peer 'AAA' sovereigns."

US bond prices actually moved up on the news (in the face of last Monday's weak stock market), and yields ended lower for the week. It's true that the markets were not caught unaware of our nation's fiscal woes. And similar to other potentially negative fundamental developments, markets participants are these days content to play the here and now - and leave structural issues for some later date.

From my perspective, S&P's summary point for why the US retains its top rating provided the most contestable aspect of their report: "The economy of the US is flexible and highly diversified, the country's effective monetary policies have supported output growth while containing inflationary pressures, and a consistent global preference for the US dollar over all other currencies gives the country unique external liquidity."

Clearly, our "flexible and highly diversified" economy was unsuccessful in thwarting a crisis of confidence for much of our private sector debt - a debacle that nearly led to the collapse of our credit system, stock market and economy back in 2008. And having witnessed our monetary policy propagate a 20-year cycle of booms and busts, I'll stick to the view that the Federal Reserve is more of a liability than an asset when it comes to prospective debt quality.

Loose monetary policy from the Fed accommodated the greatest expansion in mortgage debt in history - and now zero rates and monetization are well on their way to supporting a historic boom in government debt. And, of course, a decade of dollar weakness raises the question as to the true underlying "global preference" for our currency.

There's going to be one hell of fight in Washington over the details of deficit reduction. With too many eyes on 2012 elections, it's sure to be a challenging environment - to say the least - to muster bi-partisan compromise. Prospects for any serious near-term spending cuts are slim to none - and the markets are more than fine with this. The marketplace believes it has at least a couple additional years before the debt situation turns problematic (hence, market-impactful). In the meantime, participants are confident that the odds of big - and destabilizing - spending cuts prior to 2013 are slim. This is all in the market.


During the heart of mortgage finance bubble (2001 through 2007), total mortgage debt expanded about $7.8 trillion, or 115%. Mortgage excesses evolved to dominate the workings of the credit system, becoming the majority of total system non-financial debt growth. This source of finance provided crucial inflationary fuel for home prices, equity extraction, household net worth, incomes, corporate earnings/cash flows, government receipts/expenditures, imports and global financial flows. Over time, these flows - and resulting inflationary effects - became deeply embedded in asset prices, incomes, and system-wide expenditures. During each passing year of mortgage excess, myriad distortions more deeply affected the underlying economic structure. And every year the increasingly maladjusted "bubble economy" ensured both a more intense addiction to excess - and a more problematic process of weaning away from mortgage credit. These dynamics, to this day unappreciated by analysts and policymakers, are so crucial for understanding what got us to where we are and for appreciating that we're repeating a similar process with federal credit.

Policymakers, the rating agencies and, apparently, the marketplace never recognized how (Ponzi finance) bubble dynamics were distorting price structures throughout the economy. The credit system doubled mortgage debt and the markets pretended the quality actually improved (the price of mortgage debt increased!). Amazing as it is to contemplate, it seems that virtually no one appreciated the degree of distortions and underlying fragility.

In hindsight, it should now be clear that the mortgage finance boom inflated home prices to unsustainable levels. As important, this atypical expansion of finance inflated incomes and government tax receipts, while distorting the pattern of spending and investment (good old-fashioned "Austrian" analysis).

I would argue that today's atypical expansion in federal finance is having crucial, yet less obvious, impacts on incomes, asset prices and expenditures. Ebullient markets are confident in the slow but ongoing healing process thesis (slow is good, ensuring protracted ultra-easy monetary policy). In reality, fragilities quietly and methodically continue to mount. The system is in desperate need of balance and restraint - but is receiving the opposite.

From S&P's report: "In our baseline macroeconomic scenario of near 3% annual real growth, we expect the general government deficit to decline gradually but remain slightly higher than 6% of GDP in 2013. As a result, net general government debt would reach 84% of GDP by 2013."

It is worth highlighting that some forecasts for Q1 growth have dropped to as low as 1.5%, a dismal showing considering unrelenting extreme fiscal and monetary stimulus (and resulting stock market gains). Not surprisingly, the boom in federal finance is having a more muted economic impact when compared with that from previous mortgage excess.

The mortgage bubble inflated the perceived net worth of most homeowners, while inciting huge booms in construction and consumption. Today's boom has certainly been instrumental in stabilizing incomes (at an inflated level), although asset price gains are benefiting a narrower cross-section of the general population. Meanwhile, a large portion of the populace is today suffering from meager (negative real) returns on their savings - while losing out to rising inflation.

I'm confident that S&P's baseline case is too optimistic.

"Austerity" at the state and local level - and perhaps even a little from Washington - is poised to restrain an unbalanced recovery. While no one wants to admit as much, US and global economies are increasingly susceptible to highly speculative and unstable global risk markets. And with US private-sector credit growth remaining almost non-existent, I believe S&P's and others' estimates for the growth in federal receipts will prove overly optimistic ("output" financed by federal government borrowing and spending will not resolve fiscal troubles).

The odds of a recession over the next few years are not low. And I would argue strongly that the longer the government finance bubble runs the more difficult the adjustment when this vital source of finance is scaled back. At the end of the day, massive expansions of a particular strain of credit - albeit mortgage, household, corporate, or government - are destabilizing and difficult to normalize from.

And I refuse to take seriously recent intentions to begin addressing this problem until I hear leadership - from the Halls of Congress, from the Oval Office and from both parties - commit to sticking with spending restraint even in the face of recessionary conditions (weak economy and/or markets). This is where the rubber will meet the road.

We're now two years into both an economic recovery and one heck of a market boom, so politicians will talk tough and extrapolate a favorable backdrop. Yet, it wasn't many months ago that both parties were too willing to go with another round of borrowing and spending stimulus. I fear both parties will have a very difficult time parting ways with the notion of government as economic/market backstop. I'm not sure the public is really ready to part ways.

Greece's two-year borrowing costs surpassed 23% last week. They were around 2% in November 2009, back when markets were more tolerant of sovereign borrowing transgressions. And, yes, I know we're not Greece. And I'm not suggesting that Treasury borrowing costs are heading to 20%. But just as mortgage risk - as well as sovereign risk for Greece, Portugal, Ireland, and Spain - was mispriced throughout the bubble period, I expect that there will be re-pricing of Treasury (and related) risk in the future. An over-liquefied marketplace today under-prices credit, inflation and liquidity risk, in the process accommodating incredible double-digit to GDP deficits. My base-line case has Treasury borrowing costs at some point unsettling Standard & Poor's, the Congressional Budget Office and the markets.

I'll argue that today's debt-to-GDP ratios are understating the severity of the debt problem in many ways: measures of debt do not include the enormous contingent liabilities; debt service costs have been pushed down by the Federal Reserve and global monetary policies; and GDP is being inflated by government spending excess and a lot of other "output" that won't support the capacity of our economy to repay its obligations. But like so many aspects of this bubble, there is gray area enabling the optimists to take the other side of the argument.

The late-nineties technology/Internet bubble was spectacular, and many (including former Federal Reserve chairman Paul Volcker) worried that it was of sufficient scale to bring the system down. Yet, from a credit standpoint, it really wasn't systemic. The bubble fueled huge distortions in the tech sector, boosted home prices in a select group of cities and flooded California with tax receipts (which they quickly spent). The mortgage finance bubble was the first systemic bubble - impacting incomes, asset prices, corporate cash flows and government finances throughout the economy. The creditworthiness of federal debt proved the key - really, the momentous - advantage the system used to survive the bursting of the mortgage/Wall Street bubble.

The government finance bubble is the second - and concluding - systemic bubble. It's bigger in dimensions than the mortgage bubble and is having more problematic systemic effects on incomes and the financial markets. In particular, acute vulnerabilities resulting from the previous bubble period now ensure that, in particular, the municipal debt and mortgage markets remain susceptible to any retrenchment in federal spending (or rise in market yields). And, importantly, there is no potential creditworthy debt issuer of last resort waiting in the wings to bail out the system when market confidence in US government debt falters. Ironically, the bigger the bubbles get the less conspicuous they appear to most.

S&P puts the odds of a US debt downgrade in the next two years at 33%. Treasury Secretary Timothy Geithner says it's zero. I'll put the probability of a downgrade in the next few years at close to 100%. Until proven otherwise, I'm going to presume that policymakers will at some point come to the recognition that the economy and markets are vulnerable. They will choose to hold off on the difficult decisions - that is, until the markets force their hands.