United States At a Crossroads
ByOn August 6th 2011, the United States made history by losing S&P’s perfect AAA credit rating. We have held the perfect credit rating since 1941, 70 years of supremacy. The United States is at a crossroad. We can follow the path of countries that have lost their rating, survived, and eventually prospered again or follow the path of countries that have tried to spend their way out of insolvency. The choice is ours and a choice we should be thinking about for the 2012 election.
Before I jump into the history lesson for the day, let me set the context by explaining the elementary moral of the laws of economics. As they say, “economics is the painful elaboration of the obvious.” And while this old joke is true, the laws of economics do not bend or bypass stature. This is why we call them laws. There is no immunity to a government or an individual who accumulates too much debt. You either have to spend less and balance or face insolvency. The same law of economics applies to the United States Federal Government.
Our first option is to implement austerity measures. Australia, among other countries, should be looked to for inspiration. Australia went through a downgrade experience. In 1986, both Moody’s and Standard and Poor’s downgraded Australia’s foreign currency rating. Australia was downgraded a second time in 1989, after little action was taken to make the necessary changes. The shockwaves of the second downgrade sent Australia into a deep recession. The treasurer, Paul Keating, cautioned that Australia was in jeopardy of becoming a “banana republic.” Instead of running budget deficits and playing the blame game, he altered the direction and, after two years, delivered the first surplus. “But that did not get our credit rating back,” Keating said. “We did not recover our AAA rating until 2003.” It took a little over 17 years after that first downgrade for to Australia completely recover.
Canada also endured a manifold stage downgrade over a period of several years. In October of 1992, S&P dropped Canada’s foreign debt rating by one notch from AAA to AA+. Interestingly, there was little impact on Canadian markets. Moody’s followed S&P and downgraded the foreign debt rating by one notch. The 10-year note increased 0.45% over the subsequent months and stocks plunged 6%. In April 1995, Moody’s downgraded Canada again. In reaction to the downgrades and severe negative economic news, Canada enacted strict budget reforms. Prime Minister Jean Chrétien slashed federal spending by a monstrous 20%. He fired 23% of public sector workers, raised taxes, cut defense expenditures by 15%, lacerated certain subsidies by 40% to 60% and eradicated some ministries completely. Canada did not regain the prestigious AAA rating until 2002.
There are two things to be cognizant of in the next few years. Both Australia and Canada reported minor hiccups in economic growth after the 1st downgrade. It was only after the second downgrade did both countries experience a chain reaction to brutal economic consequences. They also reacted with swift and bold changes only after the second downgrade. If history is any guide, not much will change with the 1st downgrade. As it sits now, S&P has the United States on a negative outlook. It only seems reasonable to assume we will be downgraded again. A second downgrade seems especially eminent because Congress has such a wide ideological rift in remedy for the debt problems. The second thing to be aware of is the status of other AAA rated countries. Besides Australia and Canada there are 12 other countries with a AAA credit rating. The other countries are Austria, Denmark, Finland, France, Germany, Hong Kong, the Netherlands, Norway, Singapore, Sweden, Switzerland and England. In the near future, I can see most, if not all, of the European nations challenged with a downgrade. France and England seem especially vulnerable in these volatile times.
Option number two is to inflate our way to “prosperity”. Quantitative easing is a fancy way of saying the Fed is going to print (or as they say “digitize”) money to ease our debt and stimulate the economy. Hoping that this will pave a way for a brighter economic climate is just as wishful as magically finding the other side of the rainbow. It does not work. The by product is always inflation or hyperinflation. Inflation is a law of economics. History is my witness.
Think Weimar Republic, Germany, post World War I. The German Mark ratio to the U.S. dollar was 4 to 1 near the end of the war. It was 8 to 1 in 1919, 250 to 1 in 1921, and 2000 to 1 in 1923. Hyper-inflation hit so hard that newspapers sold for $100 billion marks! It was reported that most people were paid by the hour so individuals could purchase goods during their lunch break before the mark slipped further into the value of nothing.
In 1989, after years of massive budget deficits that were financed with borrowing from abroad, the Argentinean government resorted to the printing press. Hyperinflation soon kicked in. It was reported that grocery stores did not price any inventory. A man with a microphone would broadcast the prices of numerous items, frequently increasing the price every few hours by 30% or more. Workers would get their pay in cash and dash to the store to buy anything. By the end of the week their pay would be worthless.
Zimbabwe has been plagued for years with colossal deficits. In 2008, Zimbabwe’s annual inflation rate reached 516 quintillion per cent, that is 516 followed by 18 zeros. For the common Zimbabwean, the end result is atrocious. They must spend money as soon as they get it before it loses its value. The dysfunctional economy means that goods are in dreadfully short supply and they must spend hours searching for things to buy.
Of course, these are extreme examples however it goes to show, inflation is not a theoretical issue; it is reality. There are many other examples such as Hungary (1946), Japan (2001), and the United States (1933).The history and consequences of hyperinflation is required material in most Latin American schools. The United States is not exempt to these fundamental laws. Expect QE3 to be on the horizon despite many assertions to the contrary.
We are at the crossroads of a very important historical decision. Quantitative easing is the hail marry of economics. It is the last resort. For the sake of the future of this country, I hope we can find a way to reduce federal spending and find a way to balance. It really is the only way of out of this hole.
Brandon Saylor
-Associate