The New Republic, August 27, 2011
Most adults know that there is no Santa Claus. They should also know that there was no stock market crash associated with the Standard and Poor’s downgrade of U.S. government debt. However, because powerful interests want to spread misinformation about the downgrade, people are likely to be much better informed about Santa Claus.
Before addressing the specifics of the S&P downgrade and its impact on the market it is important to discuss some background. S&P gave investment grade ratings to hundreds of billions of dollars of subprime mortgage-backed securities – the asset at the center of the 2008 financial crisis. It also gave top investment grade ratings to both Lehman and AIG until the days of their bankruptcy, or bailout in the case of AIG. It also gave Enron a top investment grade rating until just before its collapse. Anyone relying on S&P’s assessments of creditworthiness would have lost a lot of money in recent years.
The specifics of the U.S. downgrade are consistent with S&P’s past performance. The Treasury Department uncovered a $2 trillion error in S&P’s calculations, but they still downgraded the debt anyhow. It is also worth asking why S&P decided to downgrade when we were cutting our deficits rather than when we were raising them by extending the Bush tax cuts last December. If the lord works in mysterious ways, then the ways of S&P are heavenly indeed.
It would also be worth asking what S&P was saying with this downgrade. U.S. government debt is payable in dollars. The U.S. government must pay a certain amount of interest every year and then pay the principal when debt comes due, all in dollars. The U.S. government prints dollars. This means that if we ever reach a point where it is not possible to tax enough to pay our debt or to borrow enough, the U.S. government could always just print the dollars needed to repay its debt.
There are reasons this would not be desirable, most obviously the risk of inflation, but does S&P really think that we will forget how to print dollars? S&P could say that inflation is a form of default, except that they never said that in the past. We were not downgraded in the 70s even when inflation got into the double-digits. Furthermore, if S&P now expects the dollar to be eroded by inflation, and this is one of its criteria for default, it would have to downgrade all dollar-denominated debt everywhere in the world.
But S&P just downgraded U.S. government debt; therefore we can assume that it was not applying this inflation criterion for its downgrade. That is probably a good thing, since S&P is not in the business of making inflation predictions.
Of course even if the basis for the downgrade was bogus it still could have had a serious impact on the stock market. However a little common sense shows this is not true.
The S&P downgrade was most immediately a statement that U.S. government debt is more risky than had previously been believed. If anyone takes S&P seriously then it would mean that they attach a higher risk premium to holding U.S. government debt. This is the exact opposite of how the financial markets reacted. Bond prices soared as the yields on U.S. Treasury bonds fell to near record lows. It was as though the markets with one loud yell screamed out “we spit on your downgrade S&P!”
So why did the stock market plunge? Most policy people in Washington don’t know about it, but there is a currency across the Atlantic called the "euro." The euro was on the edge of collapse because the debt crisis that was affecting some of the smaller governments was spreading to the euro zone giants: Spain and Italy.
It will be very expensive to support the debt of these countries. On the other hand, if they are allowed to default it would be a massive blow to the European banking system. This would likely set off the same sort of chain reaction and freezing up of the financial system that we saw after Lehman collapsed in September of 2008. It is not surprising that the very realistic fear of another worldwide financial collapse would send the stock market tumbling.
Tracing the reasons for the stock market plunge is not an idle exercise. There are many politicians and people in the media who are anxious to push the downgrade market crash story to advance their agenda. The moral of their story is that we got a huge market plunge because we did not reduce our deficits enough and then S&P had to downgrade the government. If we don’t straighten up and take our medicine, then S&P or one of the other credit agencies may do it again, and then we will get an even bigger market hit.
This then leads to the conclusion that we have to cut Social Security, Medicare and Medicaid, the huge social welfare programs that most of the working population either depends on now or expects to in their retirement. These are hugely popular programs among people of all ideologies, including Tea Party Republicans. Few politicians want to be associated with major cuts, but if the markets will crash otherwise there really is no choice.
As a practical matter, the stock market actually has little impact on the economy. Firms rarely rely on stock issues to directly raise capital for investment. More typically shares are issued to allow the original investors to cash out.
The main impact of the stock market on the economy is through its effect on consumption. Economists generally estimate that an additional dollar in stock wealth will lead to 3-4 cents in additional consumption. This means that the $2 trillion lost at the low of the market would eventually imply a drop of $60-$80 billion in annual consumption (0.4-0.5 percent of GDP) if the market stayed at its bottom. That’s not trivial, but it’s hardly a disaster even in an economy as weak as ours.
The real story of the stock plunge is that it matters hugely to that small segment of the population that has substantial sums invested in the market. While less than one quarter of the population owns more than $25,000 in stock (including indirect investments though mutual funds and 401(k)s), virtually all the people involved in national economic debates fall into this category. This includes economists, reporters with major news outlets and senior congressional staffers and their bosses. The stock market may not matter much to the economy, but it matters hugely to the people who make economic policy.
This is why the story of the S&P stock crash is so important. Those pushing this line know that if they can get it accepted, cutting Social Security, Medicare and Medicaid is a done deal. Hey, no one wants to cut these programs, but it would be an economic calamity if "we" didn’t step up to the plate and take the medicine. There is nothing more dangerous than a rampage of frightened policy wonks.
This means that we have to tell our stock-market-addicted policy makers that it wasn’t the downgrade that sank their retirement funds. If they are concerned about their 401(k)s they should demand stronger measures from the European Central Bank to support the euro. And, they should leave everyone’s Social Security, Medicare and Medicaid alone.