1) Pimco's Gross: U.S. at Risk of Losing AAA Rating

Bill Gross, manager of the world's biggest bond fund, warned on Thursday the United States will eventually lose its top AAA credit rating, a fear that had already spooked financial markets on Thursday and could keep the dollar, stocks and bonds under heavy selling pressure.
- Reuters, May 21, 2009

This morning there are about a hundred or so news stories screeching some version of this headline. The angle is that when the manager of the "world's biggest bond fund" warns that the U.S. is in risk of losing it's triple A credit rating, we'd better listen. It's an ominous story, but there's something a little off about it. Maybe it's these awful flashbacks that keep tackling me from behind while I'm trying to work.

Flashback: Pimco's Gross Lets the Freak Out
"It is under such dire circumstances that the social order begins to disintegrate and people find themselves doing things they previously would have thought unimaginable; drinking nail polish remover, sniffing airplane glue, tying a bag filled with fresh spray paint over your head. Hence, the Ancient Chibchan aphorism: "You never know what water you will drink." Only a fool would tromp recklessly on Chibchan wisdom. Or an ignoramus. These days it's hard to tell the difference between the two, and normally safer to quietly tiptoe around the situation when someone like Gross lets the freak slip out. But the stakes have been raised to a point where we all have something on the line now. It's like watching someone stuff hundred dollar bills into a crooked slot machine and then waking up to the realization that that someone is you."

Admittedly, it is unorthodox and generally frowned upon to continually quote oneself the way I do. But in the Age of Self Evidence it is increasingly dangerous to rely on outside sources. Especially outside sources with more than $150 billion at stake in the U.S. bond market. Ah, oh yes. Now I remember what seems a little "off" about this story; It's old.

Moody's Says U.S. Credit Rating at Risk
Financial Times
January 10, 2008

Oh yeah, 2008. But success in the bond market is all about timing.


2) America's AAA Rating at Risk... Part I

Among those who have been talking about America's credit rating risk for years is David Walker, chief executive of the Peter G. Peterson Foundation and former comptroller general of the U.S. More recently, Walker put together a detailed piece on the U.S. triple A credit rating and why it is in danger of being downgraded:

America’s Triple A Rating Is at Risk
By David Walker
Chief executive of the Peter G. Peterson Foundation and former comptroller general of the U.S.
Published: May 12, 2009
Financial Times

"The US government has had a triple A credit rating since 1917, but it is unclear how long this will continue to be the case."

According to Walker, there are two things that could cause the credit rating to be downgraded. One, a ham-handed attempt at much-needed comprehensive health care reform that ignores the nation's present financial condition. Two, failure by the federal government to create a process that would enable tough spending, tax and budget control choices to be made.

Of course, one could argue the U.S. is hardly deserving of AAA-rated credit right now. And Walker does: "How can one justify bestowing a triple A rating on an entity with an accumulated negative net worth of more than $11 trillion and additional off-balance sheet obligations of $45 trillion? An entity that is set to run a $1.8 trillion-plus deficit for the current year and trillion dollar-plus deficits for years to come?"


3) Why Does a AAA Credit Rating Matter?

As is the case when you go down to the bank and apply for a mortgage, credit ratings matter. But in the case of the U.S., the world's largest economy, what is really at stake with a credit rating? On the surface, reduced access to much-needed borrowing thanks to the perception of an increased risk of sovereign debt default.

This all sounds like very inflationary stuff, no? After all, an increase in borrowing costs, interest rates, at the same time the government is busy trying to print more dollars to reflate our way to prosperity would be disastrous. Some are calling it the "Zimbabwe Solution." But it doesn't have to be so.

Before we get too puffed up about the "Zimbabwe Solution," let's consider a little history. Sovereign defaults have been occurring for centuries. Our most recent experiences with sovereign defaults have been within emerging markets economies; namely, Argentina, Russia and Ecuador. But France defaulted on its sovereign debt eight times between 1500 and 1800; Spain 13 times between 1500 and 1900. 

Moreover, a sovereign default doesn't have to mean a complete repudiation of all outstanding debt, as a 2007 paper by Juan Carlos Hatchondo, Leonardo Martinez, and Horacio Sapriza, "The Economics of Sovereign Defaults," notes. "Most default episodes are followed by a settlement between creditors and the debtor government. The settlement may take the form of a debt exchange or debt restructuring. The new stream of payments promised by the government typically involves a combination of lower principal, lower interest payments, and longer maturities."


4) Sovereign Debt Default: It's Not the Problem, It's the Solution

In fact, rather than fearing a credit downgrade, and... what?... a potentially embarrassing sovereign default for the U.S. that would follow? Maybe we should consider what our alternatives are and what, exactly, a default on our debt really means. Murray Rothbard discussed these alternatives in an article that appeared in 1992, "Repudiating the National Debt."

"[T]he standard economic argument is that [government debt] repudiation is disastrous, because who, in his right mind, would lend again to a repudiating government? But the effective counterargument has rarely been considered: why should more private capital be poured down government rat holes?"

"It is precisely the drying up of future public credit that constitutes one of the main arguments for repudiation, for it means beneficially drying up a major channel for the wasteful destruction of the savings of the public. What we want is abundant savings and investment in private enterprises, and a lean, austere, low-budget, minimal government. The people and the economy can only wax fat and prosperous when their government is starved and puny."

Starved and puny, indeed.

It is rather ironic to me that inflationists cite a potential downgrade of the U.S. AAA-rating as evidence of a coming massive inflation. Friends, it doesn't have to be that way. A debt repudiation by the U.S. government, if followed by Rothbard's prescription for "drying up a major channel for the wasteful destruction" of our savings and an "abundant savings and investment in private enterprises" would actually be deflationary in the best possible sense of the word.

The risk is we face as a society is the same risk any debtor faces when entering bankruptcy, the possibility of the inevitable extension of still more credit that results in a wasteful destruction of savings; in other words, the creation of the serial defaulter. 

As Rothbard warns, "In order to go this route, however, we first have to rid ourselves of the fallacious mindset that conflates public and private, and that treats government debt as if it were a productive contract between two legitimate property owners."


5) News & Weirdness for Friday

Dollar Hits Five-Month Low - Financial Times
The dollar has has fallen 10 percent since hitting three-year high on trade-weighted basis in March.

Geithner Calls for `Very Substantial' Change in Wall Street Pay Practices - Bloomberg
Geithner says Wall Street’s pay practices encouraged excessive risk-taking and helped precipitate the financial crisis.

Caroline Baum: Inflation `Cure' Exposed When In-Laws Move In - Bloomberg
The piece makes an excellent point about inflation as "snake oil," backed by the authority of perhaps the world's preeminent authority on the peddling of snake oil:  "Kevin Depew, executive editor of Minyanville, chides the economists for peddling snake oil, which is what inflation is," she notes.

Credit-Card Law May Reduce U.S. Consumers' Purchasing Power by $90 Billion - Bloomberg
“The unintended, unpleasant, undiscussed consequence of this legislation is that banks will cut credit to reduce exposure to future loan losses,” said Robert Hammer, chief executive officer of R.K. Hammer Investment Bankers, an adviser to card companies. (Not that he has a vested interest against the credit card bill or anything.)

Card Firms' Loss Tally: Billions of Dollars in Fees - WSJ
The real unintended, "unpleasant" consequence of this legislation is that banks like Bank of America (BAC), Citigroup (C) and even companies such as General Electric (GE) and Target (TGT) will lose billions in fees that were formerly charged to risky borrowers.

"Trickle-Down" Economics Really Works: Wall Street's Contraction Trickles Down to Main Street - Bloomberg
The finance industry’s contraction may wipe out $185 billion in wages and profits, or $600 for every man, woman and child in the U.S., according to Thomas Philippon, a finance professor at New York University’s Stern School of Business.