6 Aug 2011

What to watch as America awakes to financial vulnerability

There are many people trying to play down the significance of Friday’s dramatic release by Standard & Poor’s that the world’s only superpower had been stripped of its AAA status, to be replaced with AA+.

No-one knows what the impact of this will be in the markets on Monday. It might well be brushed off, but I fear what Donald Rumsfeld might refer to as an “unknown unknown”.

What it symbolises however is the start of a fundamental change in how the world economy works, a change that could occur benignly, but increasingly seems like occurring chaotically.

Some quick context. It means that S&P ranks Guernsey as a safer debtor than the USA. It means that the United States is ranked on a par with New Zealand and the currently government-less Belgium.

And that Microsoft, Johnson & Johnson, and ExxonMobil are all seen as safer homes for creditor money than the nation state that is their home.

Forget the drama about Friday’s back and forth negotiation with the US Treasury and White House (though I would like to know if they afford such a courtesy to Greece or Ireland or Tunisia). This has been a long time coming.

The debt ceiling debacle has finally allowed one of the previously frightened agencies to go with the courage of their convictions and issue a downgrade that would have come a long time ago, if this were a different country.

Reading through Standard & Poor’s documentation this is not great for President Obama.

Blame seems to be fairly equally shared out between the Tea Party’s refusal to countenance tax rises (Federal VAT in the US is the obvious solution) and the refusal to deal with rapidly rising Social Security and Medicare spending.

Above all the political farce in DC, may just be democracy in action, is the main force that has greatly damaged the US in the eyes of creditors.

This is a giant searing wake-up call for the US: “You can no longer take your creditors for granted”.

The free lunch is over. Yes Americans, Congress and the White House matter hugely, but so do the people, around the world, who underpin your high spending lifestyle.

But that is just the start. What does China do next? Float its currency, and increase domestic living standards at the expense of its exporters, and stop buying US Treasuries?

What about America. A third round of Quantitative Easing, QE3, was on the cards anyway. Now it will be seen as a provocation, an attempt to monetise debts that are becoming unpopular around the world. What will happen to US inflation? The dollar should tumble. This should have been the euro’s moment. But then you get into Currency War.

In the short term, watch China. Watch the impact on Fannie and Freddie, the state-like enterprises that underpin most of the US mortgage market. And of course all of this comes at the worst possible moment with financial markets already in riot mode of the Euro.

The dollar’s status as sole reserve currency is utterly unsustainable. And US politics is incapable of delivering for its global creditors. There will be more downgrades.

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