The Emperor Has No Clothes

Once again, we have found out that in today’s times, nothing is impossible. The creditworthiness of the United States was a sure thing, unchangeable and at the highest possible level since 1917. For 70 years, S&P thought of the United States as a debtor, but nonetheless, one without the possibility of default.

The scale of the events of this past weekend can only be compared to the fall of Lehman Brothers or the 9/11 terrorist attacks. They had no right to happen, and yet, they did. The question remains as to whether the markets will react the same way as they did after those two events.

On paper, the rating downgrade is not the end of the world. The fact that the U.S. has maintained such a high rating at all is incredible, especially after the American debt grew by 250 percent over the past decade to the astronomical number of $14.3 trillion. In that same time period, the U.S. economy grew by 44 percent, which means, if trends continue, American debt would constitute 170 percent of GDP, catching up to Japan percentage-wise; but in terms of raw dollars, the debt would amount to half of the world’s GDP. The basic amount of interest payments on such a debt would be astronomical. For an economy like America’s, an interest payment amounting to 4 percent of GDP would amount to bankruptcy. What’s more, the American debt is 90 percent foreign-owned, which constitutes a potential political and security danger.

The fact that the American credit rating was downgraded is not the most important part of the narrative. What is more important is how the United States got to that point. The AAA rating survived repeated downturns, recessions, depressions and wars. It was a point of pride for Americans. The rating, however, was more of a vestige of the past than a reflection of current realities. It should be noted that conspiracy theories that the rating agencies are trying to influence the American economy are bogus. Had they announced the rating downgrade one day earlier, the market’s plunge would have been twice as bad.

The S&P decision has some far-reaching consequences. The United States has no choice but to keep borrowing, but the rate should slow down somewhat and the cost of borrowing should rise by 70-80 base points. The cost of paying off this debt will rise as well, which will affect the American consumer, who is already not doing well. The behavior of the markets in the next few weeks will be interesting. There is no alternative to the huge market that is the trade of American debt. The frank, yen and gold would not be able to absorb the reallocation of capital. It is possible that even though the U.S. credit rating was downgraded, American ten-year notes might actually go up in value. The credit downgrade has put many institutions in a bind since they are legally required to only invest in assets with an AAA rating. The sale of the notes might slow down, however.

In the next couple of days, we can expect a continuation in market fluctuations. Investors will look for new and safer places to invest their money. Gold and the Swiss frank will be in high demand.