The last decade, the US has fought many wars. The wars in Iraq and Afghanistan being the most prominent. Now, another one has begun. Luckily, this one will not require young men to be sent off to fight in foreign land (although in the current economic environment, some may be forced to emigrate).
The United States constitution gives the President the right to declare war. And that’s what Obama has done, against the ratings agency Standard & Poor’s (typically written as S&P).
Last friday, as I’m sure most of you already know, S&P decided that the US was no longer worthy of its AAA rating. Nasdaq and Dow Jones fell 6.9 % and 5.5 % respectively. While I believe markets will recover somewhat tomorrow (as is common after crashes), it is still a very serious situation. As markets collapse, the President keeps telling us that the US is still a triple-A country, and that S&P doesn’t matter. I’ve already written two posts about the downgrade where I’ve explained why it’s serious. I’m not going to rehash everything. I’d just like to share some thoughts and conclusions I’ve drawn from today’s events.
Do S&P understand politics? Either way, they’re right
Defenders of the administration claim that Standard & Poor’s judgment is based on their understanding of the political situation in the US. One of the reasons for the downgrading, essentially that US politicians don’t take economic matters seriously and that partisanship makes change nearly impossible, has been attacked with one defender saying that in order to say something about the political situation in the US, you should have a degree in Political science, not an MBA. And there are no political scientists at S&P, so they should not take the political situation into account when they make their ratings.
I’ve long argued that markets do not know how to measure political risk. Like I said in an earlier post, just a few days before Aug. 2, when no solution was in sight, investors thought the risk that the US would default within a year to be 1 in 2000. Anyone with just a basic understanding of American politics knows that it was a whole lot bigger. Maybe it was overblown, but it was certainly higher than 0.05 %.
Let me reveal one thing to you; most traders are math guys. They like mathematics, statistics and computers. They frown at political science and every other “liberal arts” topic. If they’re unsure about where to invest, they won’t read the constitution – they’ll just let their computer run their favourite valuation model which will tell them what to do. The only time they pay attention to politics is when they’re about to get a bailout. Even those who are not as heavy on math (yes, there are still investors who rely on their gut feeling) still won’t have much time to follow politics as they work longer hours than most of us.
I don’t know whether there are any political scientists at S&P. I do know this: They’re right. They’re absolutely right. Whether its by luck or not, S&P are completely right in that the political culture in America prevents it from making the kind of changes that are necessary to prevent default.
I think the reason why the market fell so much today is because many traders finally saw this. They’re not that interested in politics, and so they probably don’t think much about this stuff themselves, but if Standard & Poor’s says that the US government is dysfunctional, they trust them on that. And sadly, they’re right in doing so.
Obama lied, the stock market died… or
When Obama finally broke the silence today, markets fell even more. I suppose investors expected him to lay out a plan to fix the deficit (since the last plan obviously wasn’t good enough). That would have been the rational thing to do, and in economics as well as finance, we assume that people are rational. Sadly, that assumption doesn’t always hold.
Personally, I think Obama was immature when he practically declared war on S&P instead of focusing on solutions. He kept insisting that the US is still a Triple-A country, and he even mentioned that Warren Buffet agrees with him. Isn’t it interesting though, that markets are crashing even though the US is still supposedly a AAA-country? Clearly Obama will live to regret that claim. On the other hand, interest rates on bonds are down so far (as investors flee the stock market). However, it’s not as good as it seems: When share prices go down, tax revenue falls too. Remember the US (like most countries) has a capital gains tax. With capital gains down, tax revenue will be down too. And unemployment will be up as consumer confidence is shattered when consumers watch their savings go up in flames for the second time in less than three years.
It is clear that investors no longer trust Obama. In the midst of a stock market crash, he essentially claimed that everything was alright. And if it wasn’t, it wasn’t his fault. And since it’s not his fault, I guess he doesn’t think he has to do something about it. The US is set to borrow more than a trillion dollars a year for the foreseeable future. Even more if, as I think, you’re entering a second recession. It’s utter vanity to claim that American bonds are risk-free and worthy of a top rating under these circumstances.
To understand this better, let’s look at some other triple-A countries: Sweden has a lower national debt today than in 2006. In the UK the government is really tightening the belt. Germany and France are two of few stable countries in the Eurozone and because of their relatively good economies, they are responsible for saving the rest. I live in Ireland and I hear about people emigrating to Australia (another AAA-country) all the time. They also have lots of natural resources there. Just like Canada, another AAA-country which didn’t have a huge property bubble like the US and are therefore now in a much better shape. Norway is self-sufficient due mainly to the oil industry.
All those are AAA-countries. It’s quite clear that you don’t belong and really should have been downgraded long ago. And if you ever want to join the club again, you have to understand that you as of now do not deserve membership.
The first step to solving a problem is to admit that it exists. I look forward to the day America will once again have a president who does that, not only through words but through actions. Actions do speak louder than words. Right now, we’re at the stage when everything has been said but yet nothing done.
Hopefully the next president can change that. Time will tell.