In my post yesterday, I wrote a long analysis of the downgrading of US debt. I summarized the consequences that may or will follow, and I also countered some of the arguments that are being made by those who claim that this downgrading doesn’t mean anything.

However, there was one such argument that I forgot. Maybe its better that way, because it definitely deserves its own post: That there is no alternative to American bonds, and so investors will have to continue to buy them.

America, they say, is the only country that is issuing bonds en masse; there is no other economy big enough to do that. So if investors want to buy bonds – and virtually all investors want to hold at least some bonds as part of a diversified portfolio – they have to buy American ones. The other countries don’t issue bonds in the necessary quantity. And since investors are now fleeing the stock market looking for safe investments more than they’ve ever done before, there will be no problem selling US bonds, even if they’re somewhat riskier than they were a decade ago.

There is certainly some truth to this argument. But not a whole lot.

I have found four flaws in this argument that I’m now going to explain to you. In no particular order:

1) IBM. No, I don’t mean that the company will suddenly issue corporate bonds that can compete with the US government bonds. I mean that IBM 30 years ago had a very simple business idea: Who else would you turn to? They were dominating their industry, and they didn’t care to develop and really explore this “PC” thing that some lunatics said was going to be the next big thing. They were the IBM, why would they have to change? They were already the best. And along came Microsoft. My point is that competitors typically show up when you least expect them to. Just when you think you got the market to yourself, Microsoft, Apple, Facebook or Google will show up and ruin your party.

2) Commodities. Could gold become the new black… I mean, bond? Investors have already rushed to commodities as a safe investment. Whether they are we don’t know yet; many investors think there is a gold bubble going on that is bound to burst. Yet, gold bubble or not, commodities offer an alternative when everything else fails. Maybe the US would have to be downgraded a few more notches, but step by step the administration is making investments silver, gold and oil look more and more attractive. There is no lack of commodities in the world, so they are definitely a competitor.

3) Russia. I’ve long argued that Russia is a greater threat to the United States than China will ever be. Russia, after experiencing a severe financial crisis in 1998, today has an extremely low government debt, and a lot of natural resources such as oil and natural gas. This means that even if the financial system were to break down completely, Russia has natural resources they can use, in a worst case scenario for barter. We will always need fuel and heat after all. Russia is therefore a very safe investment. They could issue bonds for 700 billion dollars and still have a very manageable debt level. They could then use that money for infrastructure and education, two things they need if they want to become a superpower again. I’m sure they want that. And I’m sure that if they play their cards right, they will.

4) China. Like I said, I don’t think China is as much a threat as Russia is. China, I am convinced, does not seek the demise of the United States, contrary to what conservative talk show hosts would have you believe. See, they depend on you like you depend on them. They are the seller, you are the buyer. The salesman depends on the customer like the customer depends on the salesman. As long as China doesn’t have anyone who can replace you and buy all the stuff they produce, they won’t do anything to hurt you. They own trillions of dollars, and even if their currency is no longer strictly pegged to the dollar, it’s not like they want them to become worthless. If the dollar became worthless, they would be standing there, left with trillions of worthless dollars. So they won’t hurt you. Not intentionally, that is. However, they, like Russia, have a really low national debt. The Chinese government may try to appease their people and stay popular by borrowing money and investing in social welfare, education, infrastructure, you name it. That’s how bad things are today for dictatorship governments; even they have to do a little pork barrel spending every once in a while to keep the population calm. The Chinese GDP is 10.5 trillion dollars. Their debt is only 17 % of their GDP. They could borrow 5 trillion dollars and still have a manageable debt. Will they borrow this much? Maybe, maybe not. If they see that investors are screaming for an alternative bond market to invest in, then it will certainly seem tempting to them. And more importantly, the Chinese economy has its own troubles in the form of a huge property bubble that is bursting. The Chinese government may decide that the way to keep growth rates up is through increased government spending (if they’re dumb enough to take a lesson from Obama), which requires government borrowing. Like I said, they wouldn’t want to hurt the United States, but if they start to issue bonds en masse, then they will, since this will effectively offer investors an escape from American bonds. And the way the US is handling its fiscal policy, that’s definitely an escape investors will use.

Summary

Those who say that there are no alternatives to American bonds have a point. I do not believe the market will crash on monday. This is more of a slow process where investors will start to look for alternatives, and they will find them sooner or later. Whether it will be in commodities or chinese bonds, or something completely else that I’ve overlooked, is yet to be seen. When an appropriate alternative investment has been found, then you may see a run on US bonds. It’s kind of like how a lot of people didn’t really like Myspace, and so when Facebook came along, they quickly jumped ship.

However, to dismiss the downgrading by saying that there are no options is still wrong. There are options, and being downgraded will hurt the US even if it doesn’t produce the kind of runs that we’ve seen on Irish and Greek bonds in the past years.

Worst of all though, is that the fiscal situation of the United States is actually even worst than what S&P thinks. With your debt level and outlook, I wouldn’t have awarded you any A-level at all if I were working at the S&P (you should pray to God they won’t hire me once I graduate!). Like I said in my last post, this downgrading will make investors take a closer look at the US financial stability, and they may very well find that it is even worst than what S&P says. If that’s what they find, they’ll act accordingly.

And that’s when the real crisis begins.

1 comment
  1. You may want to check your China GDP data.  It may be closer to $5-6 trillion this year as opposed to $10 trillion as you say in this fine post.

    although Chinese data is notoriously hard to verify in most regards.  All we really know for sure is that ‘China is growing and growing faster than most other nations on Earth’.
    I remember back in the late 1980’s, before you were born, when everyone thought Japan was going to take over the world.  It hasn’t worked out quite that way now has it?Keep up the good work…..

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