Something seems insulting about S&P and Moody’s (NYSE:MCO) warnings on the U.S. credit rating. I don’t disagree that the U.S. fiscal situation has deteriorated significantly, and that something must be done about it sooner rather than later. However, coming from outfits that gave AAA ratings to mortgage-backed securities full of subprime mortgages, a warning on the U.S. sovereign credit just doesn’t set right. I guess all the people around the world who rush into U.S. Treasuries at the first sign of trouble anywhere are just fools.
Greece and Ireland had no currencies or central banks of their own. They shared the euro and the ECB with 14 other countries, so their sovereign debt wasn’t entirely sovereign. The United States, by contrast, has the Federal Reserve and the dollar. It is often said that countries in such positions won’t default on their debt because they can always, as a last resort, inflate their way out of it.
It’s not likely to happen that way. As private investors’ concerns about not being paid back mounted, U.S. interest rates would rise in order to be able to sell the necessary amount of debt to more reluctant buyers. The first warning would be substantial upward pressure on interest rates. This development would likely cause the government to get serious about fiscal austerity.
The Federal Reserve, at some point, would likely try to counter the upward pressure on interest rates as not helpful to our economy. As it has proven recently, it has unlimited capacity to purchase and hold U.S. Treasury debt.
Such purchases by the Federal Reserve would eventually add to inflation as the monetization of Treasury debt stimulated spending and caused much of the slack in the economy to be taken up. The more vigorous economic activity would raise tax revenues, to alleviate or partially alleviate the level of debt relative to the economy. It might well turn out to be inflating our way out of the debt situation, but, even so, holders of Treasury securities will get paid in depreciated dollars.
The job of credit agencies is to warn against default, not against inflation.