Fiscal wisdom from the guys who told you subprime mortgages were safe

Did Karl Rove acquire Standard and Poors (S&P) when no one was looking?

I mean, here we are with the Republicans screaming about unsustainable federal deficits and threatening to drive the United States into default by not approving an increase in the official debt level, and S&P decides to join the party with the threat of a downgrade of America’s AAA bond rating if Washington’s deficit isn’t brought under control tout de suite. Talk about a one-two punch.

One problem with this kind of loose talk is that it could become a self-fulfilling prophecy. If S&P keeps telling the world U.S. paper is no good, people might think that’s actually true and decide not to buy it, in which case, interest rates would shoot up, the need for further federal borrowing would only rise, and the government might well default.

It is therefore important to remember that these are the same guys who told us that subprime mortgage based derivative instruments were of triple-A quality and thereby led us down the garden path to the worst economic crisis since the Great Depression. So we can legitimately ask if the new warnings are coming from the same geniuses who deceived us before and if they know anything at all about what they are talking about. Perhaps more importantly we should ask who is paying them. Remember that the problem in the past was that they were being paid for their ratings by the very investment banks that were madly packaging more and more subprime mortgages into their so-called AAA derivatives.

Sure, the U.S. national debt has risen rapidly over the past two years as federal revenues fell in consequence of the Great Recession and stimulus spending rose to offset the job destroying-impact of falling household incomes and expenditures.  But the Wall Street Journal yesterday showed a chart of various countries with their comparative debt levels and S&P ratings. Of these countries, seven- – the U.S., Canada, France, Germany, Britain , Norway, and Australia – have AAA ratings. Spain is just below at AA and Japan at AA-. U.S. gross debt as a percent of GDP is 91.6 percent while Japan is at 220.3 percent, France at 81.8 percent, Germany at 80 percent, the UK at 77.2 percent, and Spain at 60.1 percent. 

Now, here’s an interesting point. Spain’s debt is relatively quite low. Yet, at the moment there is great fear in Europe and in global finance circles that Spain will soon not be able to borrow on the private market and will have to be bailed out by the European Stability Fund and the International Monetary Fund (IMF). I mean, there is real honest to god fear in Europe that Spain will follow Greece, Ireland, and Portugal into bail out territory and possible precipitate a similar move by Italy.

In contrast, Japan’s debt is more than twice the level of the U.S. and almost four times that of Spain. To be sure, Japan does not have a AAA rating, but no one is anticipating that Japan will have to be bailed out and, indeed, S&P rates Japan’s long-term credit outlook as stable even though it is clear that Japan will have to do a lot more borrowing and deficit spending to recover from the impact of the tragic tsunami and nuclear emergencies.

The point is that the relative level of national debt is not the only or even the most important factor in a nation’s credit outlook. In the case of the United States there is a very large factor to offset concern about the rise in its relative debt level. The U.S. Treasury market is by far the world’s biggest, most liquid bond market. Countries and institutions (China, oil producers, sovereign wealth funds) with large amounts of dollars need markets that can easily absorb or liquidate huge investments. There is only one such market – the U.S. Treasury market. It’s really the only game in town. Unlike Spain, the United States won’t have any trouble selling its paper. That won’t always be true and because of that Washington should not tarry about getting its fiscal house in order.

But it’s true now and because of that the threat of a downgrade for the United States at this moment is, well, Rovian.