Is this the first domino in the next global financial crisis? It’s possible. Today the S & P revised its long-term credit rating outlook for the U.S. from “stable” to “negative.” The immediate result has been a flight from risky assets and anything linked to optimistic views on global growth – gold and Treasuries are up, while oil and dicey currencies are down.
The big question is whether or not this is the beginning of a major inflection point in the global economy, one in which rich nations following a pattern that has long been common in emerging economies – after financial crises tend to come sovereign crises. It’s happened many times before in countries like Argentina, Thailand, and Indonesia. The question now is whether it will happen in rich nations. In other words, is it possible that the U.S. could actually loose its triple A-rating?
My feeling is that yes, it’s a real worry. The US has been triple A ever since it was first rated in 1941, but as the FT Lex column points out today, countries that are put on a negative long term outlook have a one in three chance of being downgraded over the next six to 24 months. For more on the history of how banking crises can turn into sovereign crises, check out Ken Rogoff and Carmen Reinhart’s prescient book “This Time Is Different,” which looks at eight centuries of history on this score. The upshot – yes, it can happen here. And if it did, the likely result would be a bond market collapse, a spike in global interest rates, and a financial fiasco that could make the collapse of Lehman Brothers look tame. The fallout could very well throw the world back into recession.
But the most worrisome thing at the moment isn’t so much the absolute state of the U.S. finances, which are bad, but no worse than many European nations; it’s the reason why we are in this position, namely political gridlock. Look closely at the S & P’s analysis on the long-term rating, part of which reads, “We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium and long term budgetary challenges by 2013.” It’s not so much that the challenges themselves aren’t surmountable – it’s that we simply can’t get our political acts together to surmount them.
This is an issue that comes up again and again when I am speaking to leaders abroad. I was in China a few months ago, and policy makers there were as worried about the kind of ugly populist politics represented by the Tea Party as they were about absolute U.S. debt levels. Larry Summers summed it up well at a recent conference in Bretton Woods, where he said, “not meeting our debt obligations is like allowing a child with matches to sit in a room full of dynamite.” He added, “I continue to find it close to inconceivable that elected policymakers would allow the risk of default.”
Too true. But there’s still a chance that the S & P decision could end up being a positive thing for the U.S., if it becomes a fire under politicians. As a Capital Economics report I received today pointed, out, the agency’s decision to put the U.K’s triple A rating on a negative outlook in May of 2009 prompted major soul searching there, which eventually led to tough decisions on fiscal tightening which were taken by a coalition government. The result was that the U.K was rated back up last year. Let’s hope Washington got that memo.