The Insightful Trader

As US Sovereign Credit Weakens, So Does Dollar’s Standing

by on Dec.17, 2010, under Editorials

Moody’s will consider lowering its credit outlook on US Treasurys due to the Obama/ Republican tax cut deal. If the agency decides to lower the outlook, that will open the possibility of actually cutting the rating below Aaa within 12-18 months, the rating agency said December 12.

Not so long ago, Treasurys stood above all other credits, even other sovereign credits, as the closest thing to an absolutely, unquestionably, risk free asset. Even with all our well publicized troubles, it was shocking, if not surprising, to see Moody’s discuss the possibility of a US ratings downgrade publicly.

American Leadership Still in Denial Abut Nation’s Decline

Back in early 2009 I asked why anyone thought the United States could subsidize weak banks, stimulate the economy, and maintain the status of the dollar. Oh, and fight two foreign wars? Maybe we can’t, Moody’s now seems to be saying.

After writing that post I saw this article by former IMF economist Desmond Lachman (he’s now with AEI, the Republican-leaning think tank) who had seen several currency crises first-hand.  Lachman compared the denial we operate in to that of “Argentina in its worst moments.” He concluded by saying, “In the twilight of my career, when I am hopefully wiser than before, I have come to regret how the IMF and the U.S. Treasury all too often lectured leaders in emerging markets on how to ‘get their house in order’ — without the slightest thought that the United States might fare no better when facing a major economic crisis.” If the tax deal is any indication, we don’t seem to have gotten better at facing reality since Lachman’s article appeared.

Moreover, while investor types certainly read the recent Moody’s announcement,  the announcement didn’t seem to get all that much media play. More denial.

The Dollar’s Reserve Currency Status At Risk

We’re blowing up the dollar based international monetary system, which underpins the prosperity we used to take for granted, and Washington doesn’t seem to care. Someone needs to remember that with the dollar as a reserve currency, foreign central banks hold Treasurys as a reserve asset (like, say, gold) to back their own respective currencies. But as we cheapen our credit, we fail in our responsibility to maintain Treasurys as unimpeachable, gilt-edged instruments.

While any number of analysts say that US credit is safe because we have lower debt to GDP ratios than, say, Italy or Japan, that argument misses the point in my view. If you want to have a reserve currency, your debt has be so sound, no one thinks to worry about it. That soundness used to be part of the reason why foreign central banks hold trillions of dollars. As that soundness erodes at least some pronounced selling could make sense for managers of foreign official portfolios. Somewhat better than the other guy is not nearly good enough. And once we lose our pride of place, getting it back will take a very long time.

Some analysts speculate that our economic “leadership” is actually looking for an exit strategy where we let go the burden of carrying the reserve currency, and allow it to be replaced by a composite of several currencies, something like the IMF’s Special Drawing Rights. I have three problems with this strategy, if that is what Washington is trying to do.

First of all, in such a system, countries not all that friendly to us would likely get much more say in how things get done in the world – China, Russia, possibly some of the Persian Gulf states. Do we really want that? The second problem is that by its fiscal irresponsibility, our country would presumably be negotiating the new monetary world order from a position of weakness. No longer can we say, as the late Treasury Secretary John Connolly did, that “It’s our [current account] deficit, but it’s your problem.” The third problem is that if we continue to let things drift, we risk a crisis as Lachman points out. In which case we wouldn’t be “negotiating” very much, things would be taken from us with little given in return.

Meanwhile, China keeps doing bilateral trade deals with other countries in which trade gets settled in renminbi and the dollar gets bypassed altogether. In addition to reducing the dollar’s primacy in international trade, such arrangements reduce the needs of other countries to hold dollars, making official foreign sales of Treaurys more likely at some point.

One suspects that the troubles in the Euro zone are one reason Treasurys look good by comparison, at least for now. That, and the way dollar selling got overdone earlier this autumn. Eventually, though, Euroland will resolve its troubles (for better or for worse), and then we’ll get another turn in the spotlight. If foreigners then become less willing to hold dollars, how long will we be able to pay for imported oil (or microchips, for that matter) with dollars we print so casually?

No one knows. But taking the dollar’s unique status for granted would seem to be unwise.

Moody’s Sounds the Alarm and Still Doesn’t Seem to Get It

How ironic then, that Moody’s, while sounding its alarm on Treasury credit quality, remained blind to the implications of that alarm when it released its US economic forecast. (I know, the forecast was released on the 8th, four days before the announcement on the Treasury outlook.  But in a December 6 analysis Moody’s did raise the possibility that the tax cut deal could affect US creditworthiness – which was newsworthy enough in my view—even though as of that date Moody’s was not ready to warn about a change in outlook).

Moody’s economist Mark Zandi ran the numbers and decided that, yes the tax cuts will goose the economy – and even assure the kind of recovery we’ve been waiting for. But while his company’s credit analyst Stephen Hess had started to open America’s credit rating to question, Zandi didn’t think to tell us what would happen to our economy if other countries started to doubt our credit more seriously too.

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