Preparing for the Impact of the Downgrade

by: Tim Duy

Lots of moving pieces as financial centers around the world prepare for the impact of the S&P downgrade of US debt and the ongoing Eurozone debt crisis. The list:

ECB Finally Ready to Come to the Table. The ECB is signaling they are prepared to buy up massive quantities of Italian and Spanish debt, hoping to put a firewall around the European debt crisis. Of course, this isn’t the first firewall European leaders have set, to no avail. Perhaps this time will be different. Paul Krugman argues, I think correctly, that at least for Italy the issue is seemingly a liquidity crisis, not an insolvency crisis. The ECB could effectively act as a lender of last resort in such a case, and bring about stability with only minor fiscal adjustment. My concern is that if this was just a liquidity crisis, then why did the ECB posture that significant fiscal adjustments were necessary? Just to look tough? As to whether or not the ECB is actually prepared to follow through with big bond purchases, I refer you to Yves Smith:

My readers of European press tell me that the signals this weekend was that the ECB wants to nibble only and is trying to prevent panic sales. If this reading is correct, this is a variant on the Paulson “bazooka” strategy of July 2008 with Fannie and Freddie, that if the markets knew he had a bazooka in his pocket, he would not have to use it. We know how that one turned out.

The G7 Communiqué. The G7 finance ministers and central bankers met over the weekend and more or less confirmed their commitment to fiscal austerity:

We are committed to addressing the tensions stemming from the current challenges on our fiscal deficits, debt and growth, and welcome the decisive actions taken in the US and Europe. The US has adopted reforms that will deliver substantial deficit reduction over the medium term. In Europe, the Euro area Summit decided on July 21 a comprehensive package to tackle the situation in Greece and other countries facing financial tensions, notably through the flexibilisation of the EFSF. We are now focused on the quick and full implementation of the agreements achieved. We welcome the statement of France and Germany to that effect. We also welcome the statement of the Governing Council of the ECB.

Whether the US has adopted a credible medium term plan for fiscal reform is debatable, even more so given ongoing economic weakness likely to be exacerbated by near-term fiscal austerity. What the US needs is near-term stimulus and long-term consolidation, or at least a political system capable of producing this.

Regarding the rapid implementation of the EFSF, I think this means the someone in Europe is going to have to cut their vacation short and actually get on this before the end of the month. A key paragraph:

We are committed to taking coordinated action where needed, to ensuring liquidity, and to supporting financial market functioning, financial stability and economic growth.

I think this gives the Fed cover to move this morning; more later. I like this part:

These actions, together with continuing fiscal discipline efforts will enable long-term fiscal sustainability. No change in fundamentals warrants the recent financial tensions faced by Spain and Italy. We welcome the additional policy measures announced by Italy and Spain to strengthen fiscal discipline and underpin the recovery in economic activity and job creation.

On one hand, nothing warrants the pressure on Spain and Italy – just a liquidity crisis. On the other hand, they welcome additional policy measures. Less reassuring, it has the feel of a solvency problem. Honestly, I think I would be more confident if the ECB had just stepped up to the plate and not demanded a quid pro quo. Finally:

The Euro Area Leaders have stated clearly that the involvement of the private sector in Greece is an extraordinary measure due to unique circumstances that will not be applied to any other member states of the euro area.

This is a clear line in the sand. Expect more fiscal austerity.

The Federal Reserve. As I argued last week, the usual guides to monetary policy, a combination of Fedspeak and data flow, are not conducive to a near-term policy shift. An overriding factor, however, would be financial crisis, and the G7 statement seems to raise the current circumstances to crisis level. This should give the Fed a green light to act. I still think the best option is to come in before the market opens and announce they are buying $100 billion of Treasuries. Just get ahead of this. The problem is that so many Fed policymakers have come out seemingly dead set against any additional bond purchases that action just a day before the next FOMC meeting seems like a big leap. Still, a financial crisis is a good time for a big leap.

The S&P Downgrade. Lot’s of speculation on the competence of S&P. They obviously messed up on the math. And let’s not forget the role they played during the financial crisis – aren’t any mortgage backed assets investment grade? They are if you want to keep earning your fees. But Ezra Klein and Felix Salmon argue that the circus of US politics warrants a debt downgrade. After all, a small but apparently vocal contingent thinks the debt-ceiling is no big deal, and is actually willing to press the button to prove their point.

Should the downgrade have significant economic consequences? I fear the answer is yes. First, if you believe confidence is important, that confidence has surely been shaken, as evidenced by wild ride of financial markets. Second, the political response could be a full-court press for more fiscal austerity. Finally, we don’t completely know the knock-off effects on the rest of the financial system. From the Wall Street Journal:

The downgrade late Friday had implications for a range of entities with links to the U.S. government or holdings of its debt, running the gamut from mortgage giants Fannie Mae and Freddie Mac to large insurers to securities clearinghouses—not to mention rates on consumer loans such as mortgages that are linked to Treasury yields.

The risk for all these borrowers is that the downgrade to double-A-plus, even though by just one of the three major rating firms, could result in slightly higher interest rates. Those costs might be small for each borrower, but in total could essentially mean a tightening of credit in the country at a time when a weak economy can ill afford higher rates.

The world needs more safe assets. The safest asset just became a little bit less safe. That can’t be good. The sad part is that there really shouldn’t be any doubt the US can and will repay its debt in full. Any way you cut it, this is a self-inflicted wound.

Good luck today.