… if you can print money and are in control of the credit markets. Look at Japan. That doesn’t mean the underlying problems don’t matter.
S&P’s downgrade Friday evening of U.S. Government bonds from AAA to AA+ will get us tangled up in our own underwear for a few days, but beyond that, life will go on as we know it: At the behest of Congress, the U.S. Treasury will borrow trillions, and the Fed, the enabler, will print them. Should there be a squiggle in the markets, the Fed will print even more. It has done so in the past. And there is no reason to believe it won’t do so in the future, despite some verbiage to the contrary. After all, the consequences—inflation and devaluation—are publicly stated policy goals.
In the credit markets, central banks pull the levers with their ability to “print money” and buy unlimited amounts of assets to prop up values and bring down yields. Call it “quantitative easing,” “injecting liquidity,” or whatever. A force that easily overcomes—due to its “unlimited” quality—any impact of a credit downgrade.
The shining example of why downgrades don’t matter in markets that are controlled by central banks is Japan. It expanded its government debt from 66% of GDP in 1989 to a mind-boggling 229% in 2010. Its long-term debt got whacked by every credit rating agency time and again, and in April, S&P threaten to downgrade it another notch from AA– to A+. And yet, Japanese government bonds (JGBs) have done extremely well, and shorting them has taught us the meaning of “trade of death.” For example, 10-year JGBs have been yielding in the ridiculously low range of 0.9% to 1.4% over the last few years (1.015% today). Incomprehensible in a free market.
Alas, it’s not a free market. 94% of all JGBs are purchased by entities of the Japanese government or by institutions they have on a leash: the Bank of Japan, the Japanese Government Pension Investment Fund (the largest pension fund in the world, larger even than Social Security), other pension funds, and the largest Japanese financial institutions.
Similarly, just about all of the U.S. debt issued over the last three years has been bought by the Fed and, on a much smaller scale, by Social Security. While Japan’s debt-to-GDP ratio of 229% dwarfs that of the U.S., which broke through the 100% level last week, Japan does have some advantages.
The most important is its trade surplus which has generated over $1 trillion in foreign exchange reserves, whereas the U.S. has had an astounding trade deficit for so many years that it owes other countries over $4 trillion.
Europe is now climbing into the same wobbly boat. Various countries, particularly the infamous PIIGS (Portugal, Ireland, Italy, Greece, and Spain), but also Belgium and others, have run up big deficits year after year, and their debt has reached unmanageable levels. Countries have been downgraded, some by a lot, and raising money at reasonable yields has become a challenge. Downgrades don’t matter if you can print money. But these countries can’t print their own money. Hence, the funding crisis. So what does the European Central Bank (ECB) do?
Well, when the ECB was established in 1998, Germans, who’d experienced two currency collapses in a single lifespan, insisted on de facto control over the ECB as a condition for joining the monetary union. The ECB was headquartered in Frankfurt, and rules were enshrined to prevent the monetizing of debt of member states. The Germans wanted the Euro to be as hard as the Deutsche Mark, and they succeeded: During my decades in the U.S., the dollar lost 65% of its value against the DM/Euro. They protected themselves against inflation and devaluation. And we did not.
Yet, they couldn’t just watch Italy go up in flames. So they acquiesced to an unsavory deal (announced Friday and today): The ECB would overcome the impact of any downgrades by buying failing debt from Italy, Portugal, Spain, and Ireland as fast as it can print the money. Germans who’d lost everything twice are turning over in their graves.
In this context of yields and funding, even multiple downgrades of U.S. debt will mean nothing because they’re powerless against our central bank. But it does make us think—for a moment, at least. Realistically, rating agencies should have started downgrading years ago. Mortgage backed securities were rated AAA until they were near default. The rating agencies blew it. That S&P dared to take one tiny belated step on Friday is nevertheless laudable—but without consequence. It might rejigger some values, but it won’t change our M.O. of spending money we don’t have, borrowing it until we can’t, and then printing it.