Financial Markets Must Think the Unthinkable

A new frontier awaits the world financial markets if the U.S. loses its triple-A rating for the first time since 1941. The Frankfurter Rundschau names four reasons why U.S. President Obama is exaggerating with his warning of threatening “armageddon.”

In the U.S., the creditworthiness of the country has constitutional status: “The validity of the public debt of the United States, authorized by law… shall not be questioned” is in the 14th Amendment of the U.S. Constitution. With the continued dispute about the debt ceiling, politics is edging closer to violating the constitution because the U.S. is threatened with a loss of the best rating of AAA if the parties do not agree. This would not only be fatal for Washington, but also for the whole world financial market. UniCredit economist Andreas Rees expresses it simply: It threatens “the end of security.”

If the Democrats and Republicans do not agree on raising the debt limit, the U.S. Treasury would have to stop paying interest on its debt over the short or long term. This would lead directly to a demotion by the rating agencies. But even if there is agreement, “the U.S. will not be able to keep its AAA rating over the long term,” thinks Rees, because the country has piled up too much debt.

A new frontier awaits the world financial markets if the U.S. loses its triple A rating for the first time since 1941. Does this threaten the sale of U.S. bonds and an “armageddon” as U.S. President Barack Obama recently warned? Four reasons argue against it.

First, the U.S. is not Greece and is not broke. Washington would find creditors — if the government were permitted. The U.S. is also not untenably indebted. The government could easily raise its income by raising taxes. There is a lot of leeway here. The income from taxes and expenditures of the U.S. amounts to merely 24 percent of the economic output. That is the lowest value of all industrialized nations, which average 35 percent. In short: The reason for the crisis is not the inability of the American government to pay. Lack of confidence in the markets is not forcing the U.S. to economize, it is the other way around: The economizing fanaticism of the Republicans is unsettling the markets.

Second, if global investors wanted to sell U.S. bonds, where would they go? There is no viable alternative offering security. The euro and the yen? Hardly — the European zone and Japan are themselves fighting with mountains of debt. “Safe havens” like the Swiss franc are simply too small: Franc bonds trade roughly over $100 billion in the markets. That is too little for the almost $10,000 billion invested in American bonds. “U.S. Treasury bonds comprise almost two-thirds of the global market for AAA bonds,” according to the Commerzbank. “In other words: There is a lack of a sufficiently large catch-all to make a flight from treasuries possible.”

How about investments in emerging countries like China, where the debt is still minimal? Here there are two problems: The volume here is also too small. At the same time, emerging countries would protect themselves with controls on the flow of capital and prohibition of a drastic inflow of capital, which would appreciate their currency and endanger their export model. As a last alternative remains raw materials. But they offer no security — not even gold. The price of gold has risen sharply. What investors are looking for — and find in U.S. bonds — is security and no speculation of price increases.

Third, most of the U.S. bonds are in levelheaded hands: Three-quarters of them are held by central banks, U.S. households, U.S. states and long-term investors. They will not sell hastily — not even the Chinese. Beijing needs its dollar reserves to stabilize the exchange rate of its currency against the dollar.

Fourth, if the remaining investors should throw their U.S. bonds into the market, the U.S. Federal Reserve would appear as a buyer to prevent a devaluation of the securities and thereby prevent a raise in interest.

A wild sell-off would therefore not be probable. No one is, however, certain; an “indispensable condition for the function of our economic system is confidence,” according to M.M. Warburg economist Carsten Klude. “This confidence has already been partially lost and is threatening to get completely lost.”