Bye, Bye, Triple-A. Gone, But Not Forgotten

Hello AA+.

It’s nice being ahead of the curve. On July 26, The Hedged Economist posted “The US Will Lose It’s AAA Rating.” Since then, the wait for it to happen allowed time to write four other postings that discussed the topic. So, while others are busy figuring out, or writing about, why it happened and what it means, this blog can focus on more constructive things. But, before leaving it, some explanation is warranted.

Back on April 1, 2010 this blog warned “Beware the risk-free return.” A lot of people are going to be throwing around a lot of money as they adjust to the realization discussed in that posting. The steps they have been taking, the impact of those steps on markets, and the risks that creates were discussed in the postings since July 26. For an excellent example of how risk-free return has been incorporated into financial thinking, see “S&P Downgrades U.S. and Dulls Sharpe Ratio” by Richard Shaw on SEEKING ALPHA. It may seem cavalier to dismiss the downgrade simply because it’s just recognition of a reality that always existed. That would be a mistaken impression. It’s a serious concern, but it has already been discussed.

The downgrade will have a negative impact on all of us, and it will touch off totally unpredictable consequences. Yet, to date, market responses have been exactly what one would expect when adjusting to a previously unrecognized risk. The big question is, have enough people adjusted their liquidity to levels where they can weather what will follow to prevent the adjustments from snowballing? Otherwise the liquidity phase and then counterparty-risk phase of the meltdown of 2008 will be repeated.

As this is being written over the weekend of the downgrade, the only comment The Hedged Economist has is that in “Investing Part 3: Setting the Volume” (posted on December 19, 2010) this blog provided some relevant advice for individual investors. It thus explains how some individual investors have positioned themselves to be sanguine about recent and near-term market behavior.

How we made financial markets more vulnerable to risks associated with the adjustment we are undergoing were discussed in “Liquidity Is Dangerous” (posted on May 23, 2010) and “Fictitious Liquidity” (posted May 28, 2010). But, nothing created more risk than the persistent belief that a risk-free return was a viable assumption.

The more important issue is how to get the economy growing at an acceptable rate. If the US, the government, and the population in general, display some modicum of responsible financial management, it will help. With that as introduction the question now should be how do we get triple-A back. After all, the world isn’t going to end just because the US government has demonstrated financial mismanagement. The US can continue the blame game or face reality. We all know the blame game is fun, but perhaps it’s time to start acting like responsible adults when it comes to public finance. That raises the issue of what can be done.

First on The Hedged Economist’s list of what has to be done is to get rid of politicians who say give me more money or I’ll default on what was lent to the government in the past. Trying to hold previous lenders and the economy hostage as a way to negotiate for tax increases is wrong. That’s not a statement on taxes: it’s a statement on financial management. If taxes are justified, make the case based on a real justification. A good financial manager would reassure lenders first. Then he or she would turn to methods of generating the cash needed to pay them. In short, we need leaders who say our credit is good, not one who puts politics first.

Right behind that comes getting rid of financial managers who say borrowing is the only way to meet our current obligations. It may be the best way, but it is never the only way unless the financial situation is already in the proverbial debt death spiral. As a country with control of its currency and its exchange rate as well as many national assets, the US is far from that. Further, as argued above, taxes are an alternative to borrowing. So, anyone who would say or believe more borrowing is the only solution should be given a job more commensurate with their capabilities.

For sure get rid of a financial management team that combines the two missteps above. Getting a triple-A rating back while the current financial management team is in place would only indicate that someone in the government got to someone at S&P. Because of that, it probably won’t be taken too seriously by financial markets.

Now, this isn’t a partisan issue. Those in Congress who advocate a default are dangerously close to the often quoted example of yelling fire in a crowded theater. Advocating no taxes is not the same as advocating no debt payments. The first relates to cash flow management. The second relates to the balance sheet. What’s particularly odd about combining the two is that “no more taxes” is often defended by drawing a parallel between taxes and confiscation. How this is combined with an explicit call for confiscating wealth held in Treasuries escapes this observer.

Ultimately, the triple-A rating should be based on a widespread belief that one should take paying back debts seriously. Politics isn’t the only place where American’s fail to project that image. We are a compassionate people, but our efforts to be compassionate often come off as a collective view that paying debts is optional, only to be done if convenient. Well, deleveraging is never fun, yet many American’s are doing it. It isn’t convenient.

Decent financial management isn’t a partisan issue. If it were, it would seem members of one party or the other should be indifferent to their personal credit scores developed by the consumer credit bureaus. Unfortunately, we collectively, through our politicians in both parties, have displayed just such indifference. Yet, no one in either party should overlook the fact that only one party manages the national government at any time. They’re called the executive.

The debt rating is a small part of what is needed to restore growth. Numerous bipartisan and partisan recommendations are floating around. The initial concept for this posting was to focus on one proposal. As a good economist, The Hedged Economist planned to address opportunity costs, but to avoid a broad discussion that invited philosophic debates. To do that, the plan was to restrict the options that could be discussed. The planned approach was to take a Democratic proposal, essentially concede the conceptual desirability of the proposal, and restrict the discussion to method.

In preparation, the following information was circulated to a few economist and others who have commented on this blog.
The quotes are from “White House Renews Push to Extend Payroll-Tax Cut.” WALL STREET JOURNAL (August 6, 2011)

“The payroll-tax holiday for employees was enacted in December and expires at the end of this year. By lowering Social Security payroll taxes paid by employees to 4.2% of earnings from 6.2%, it saved taxpayers as much as $2,136 each this year…The break did not extend to the 6.2% payroll tax paid by employers.”

“Treasury Secretary Tim Geithner thinks the Democrats have a winning argument, and expressed confidence Republicans would not stand in the way of extending the tax break for workers…'I think it's very hard for them to stand up and say that they're going to try to block the extension of that tax cut that's worth about $1,000 a year for the average American family,' Mr. Geithner told ABC News.”

The quotes were accompanied by a question: “Does it seem to you that they’d get more job creation if the cut were on the employer side?” To the economists, I added an acknowledgement that theoretically they are both reductions in labor costs, the intent being to avoid their having to address that issue. Well, this little experiment was a total flop in terms of its original intent. Nevertheless, it was extremely informative.

Two things stood out. The people who responded almost universally indicated a belief that this policy had no (to no measureable) impact on jobs or growth. The strongest Democratic backer endorsed it as income redistribution, but criticized the deficit impact and lack of economic impact. The strongest Republican criticized the political posturing embodied in the current structure of the tax break and its lack of impact on the economy. Economist’s focus on aggregate demand or capital formation depending on their orientation, but they viewed this particular issue as a sideshow. But, there was an almost unanimous lack of belief in the effectiveness of the measure as stimulus.

Second, an overwhelming majority of respondents, couldn’t, or wouldn’t, separate this issue from broader policy issues. Those broader issues drew them away from addressing opportunity costs within the confines of the structure of this policy initiative. One might expect that to have related to the deficit and debt issues given the downgrade, but that wasn’t the case. Deficits and debt were mentioned by some respondents, but generally the focus was elsewhere. Perhaps opportunity costs outside the confines of this issue just overwhelm this issue.

The Hedged Economist’s conclusion is that structured the way it is, this policy seems more like a vote buying program than an employment stimulus. What scares me is our Secretary of Treasury thinks that’s a win. It may be a winner on a popularity poll, but I’m not so sure it’s a win for Treasury, the unemployed, or the economy. Any small difference in effectiveness would mean fairly significant differences in new taxes paid, some greater reduction in unemployment, and more demand.

All that may seem interesting, but hardly worth noting except that opportunity costs are an important issue. My discussion of “the stimulus” focused specifically on the shortcomings of previous analysis of “the stimulus.” They set up a fictitious counter factual in order to avoid the difficult issue of addressing the true opportunity costs. (See: postings throughout September 2010 starting with “Stimulus more or less? A failure not being acknowledged. PART 1”).

Where does this lead? While good, responsible financial management is easy to identify, economic policy questions like the right level for the deficit or taxes are much harder to discuss without appearing partisan. Even separating out one small policy issue seems almost impossible. That in itself doesn’t bode well for developing an effective growth strategy. But, if we politicize our judgments about what is good financial management, continuous crisis is inevitable.