Center for World Conflict and Peace

Center for World Conflict and Peace

Sunday, August 7, 2011

Behind the S&P's Downgrade

Regardless of all the hubbub on the debt ceiling earlier this week, the S&P downgraded America's rating by one notch after all, to AA+. Even though the U.S. Treasury questioned the S&P analysis, noting that the S&P underestimated the amount of deficit reduction by $2 trillion over the next decade, the S&P is probably justified in doing so, considering the domestic political mess that occurred last week, with the Tea Party rioting, the liberals gnashing their teeth, and Boehner chain-smoking so much that the fire department was called by concerned tourists - okay, I made the last part up, but check this really funny piece by Maureen Dowd for an over-the-top description on what was going on last week in Washington.

Like it or not, "the $2 trillion debate" is academic, and the $2 trillion reduction itself may or may not happen due to various political and economic conditions and accounting gimmicks, similar to Bill Clinton's budget surplus, which relied on a "Social Security Tax."

What really concerned the S&P is whether the US has the political will to actually slash the deficit without relying on accounting gimmick. I think summed this dilemma nicely:
"We won't attempt to assign blame to one party or the other for the deficits. There is plenty of blame to go around, some of which rests with an American public that won't accept cuts in the largest categories of public spending, and also resists tax increases on anybody but "the rich."
Here's the problem: both sides are right and wrong at the same time. The conservatives are right that taxing businesses hurts growth. Besides, the US has the second highest corporate tax rate anyway, second to Japan, as admitted by the New York Times. (Check this link for the comparison to the effective EU Corporate Tax Rates.) The problem is the loopholes, as corporations are trying to find loopholes to avoid paying such punishing corporate tax rates. As a result, it is a good idea to reform the tax code.

Still, nothing brings votes easier than yelling "tax the rich" and "these evil corporate interests," right? And it is easy to call the mob to bring pitchforks and torches against somebody who claimed it was difficult to make ends meet with $250k a year. Based on a analysis, getting rid of the tax break on couples with income over $250k a year will only hurt less than a million people, and rolling back Bush' tax cut will produce $950 billion in savings annually. One should keep in mind, however, that in 2007, these people, which comprised of 10% of the population, had already paid 55% of all federal taxes and that number doesn't include local and state taxes, which will push their total tax contributions far higher.

At the same time, the liberals are right that cutting spending on various social safety net is a horrible idea as it will hurt the most vulnerable members of the society. But at this point, doing nothing to reform the entitlement system is simply postponing the inevitable, that without any significant reform, the current entitlement system is simply unsustainable. The reason? The fact that Americans are dying much later in life, along with the rapid increase of the health costs of treating people, are the main culprits of this development. But at the same time, nobody is willing to trim down the fat, which brings us to the current dilemma.

Aside from the entitlements issue, the biggest problem with the U.S. budget lies in the public sector spending. I am not against spending on things like education, but news like this or this which points out the inefficient and wasteful U.S. bureaucratic system--primarily due to the public union system--is rather alarming. Moreover, the financial crisis in Europe shows that the unbridled power of the union is one of the main causes of the inability of these troubled countries to take a much needed step to reform its economy.

How will the credit rating downgrade impact the U.S., (well, aside from probably higher interest rates)? Most likely not much will come of it, considering several factors, such as the fact that both Moody and Fitch still conditionally maintain America's debt rating as perfect. And most importantly, there probably isn't any alternative to U.S. bonds.

A few years ago, some experts argued that the Euro would eventually be the alternative to the U.S. bond. Yet events in the past years have shown the fragility of the Euro itself.

A strong currency is great in good times. It gives countries a license to splurge. For countries such as Greece, it provides credibility, allowing the Greeks to borrow beyond their means because everyone is sure that somebody will bail them out. Flush with cash, countries like Greece could opt to postpone painful needed reforms and instead cause some sort of "moral hazard," where the country would actually behave recklessly and irresponsibly because it were sure that others would bail it out in order to maintain the stability of the system.

The true test comes when times are tough. First, countries find out that they cannot devalue their currency and export themselves out of economic troubles. The market becomes wary, wondering whether other states, hurt by the economic crisis, will be willing to bail these countries out. The people become angry because they don't like painful reforms and they are getting hurt twice: first from the austerity measures and then from the economic downturn.

Such political and economic difficulties that currently engulfs Europe undermine its bid to be an alternative global currency.

What about other countries? China? Well, considering how inept it was in handling last week's train crash and various questions regarding its accounting practices, not to mention its really huge bad debts, it's not really ready yet to be a global financial powerhouse. Plus, the Yuan is a non-convertible currency, limiting its use as a global currency.

There are many other suitable candidates, such as Japan, India, Singapore, and Australia, but still, none of them has an economy as large and as influential as the U.S. currently does. 

This is why even though the S&P has downgraded America's ratings, the impact might not be especially perilous. There is simply no alternative to the U.S.

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