It’s the Economy not the S&P Downgrade

Treasury prices are rising across the board (except for maturities six months or less) suggesting that the S&P downgrade is having little or no effect on the markets.  What is affecting the markets is the overall economic outlook which is bad and getting worse.  Now it may be that the sense that economic policy in the US is out of control, which, at least in part, was the basis for the downgrade, is affecting contributing to pessimism about the future, but in that case the downgrade is merely reflecting what the market already was sensing.  But it is not quality of US Treasuries that is the issue.

From today’s New York Times story:

The decision late Friday by the ratings agency Standard & Poor’s to downgrade the United States’s debt rating one level to AA+ from AAA has global implications, said Alessandro Giansanti, a credit market strategist at ING in Amsterdam.

“We can see that this may force the U.S. to move more aggressively to cut spending,” he said, something that could drive the already weak economy into recession and weigh on the economies of all of its trading partners. “That’s the main driver” of the stock market declines, he said.

So the markets are taking fright because they are expecting more draconian cuts in government spending and perhaps increased taxes as part of an upcoming budget deal.  You don’t have to be a Keynesian to understand that slashing government spending and raising taxes precisely when the economy is starting to weaken is not good counter-cyclical policy.  But that is the program that almost everyone in Washington, gripped by a deficit-cutting frenzy, has signed on to.  The idea that we must — MUST — reduce the budget deficit is now wreaking havoc.  With the Fed apparently as paralyzed now as it was in September 2008, we are not in a good place.

7 Responses to “It’s the Economy not the S&P Downgrade”

  1. 1 Morgan Warstler (@morganwarstler) August 8, 2011 at 9:24 am

    “Specifically, the report warns directly that a further downgrade to “AA” status could occur within the next two years if there is “less reduction in spending” than what was agreed in the debt ceiling agreement. S&P said one factor that could lead to this second downgrade is if the minimum $1.2 trillion in spending cuts under the debt ceiling agreement does not occur.

    But S&P sees the continuation of the Bush tax cuts in 2001 and 2003 as something that could still allow the U.S. to maintain its new “AA+” rating.

    While this difference would seem to put a greater emphasis on spending cuts, the report more broadly seems to value both spending cuts and tax revenues as a way out of the debt crisis. S&P said it takes no position on the “mix of spending and revenue measures” needed to put the U.S. back on a path to its historic “AAA” rating, a sign that it believes both are needed in some measure.

    It also laments Congress’s failure to find a way forward on either prescription as part of the debt ceiling agreement.

    “It appears that for now, new revenues have dropped down on the menu of policy options,” the report said. “In addition, the plan envisions only minor policy changes on Medicare and little change in other entitlements, the containment of which we and most other independent observers regard as key to long-term fiscal sustainability.””

    Question for you David, since you like explaining what the market thinks…

    HOW WOULD the ‘market’ respond to an announcement that all public employees (sans soldiers) will be paid 25% less, so that the 16M unemployed can be hired and paid $25K per year?

    So the hypothetical is: No new spending, but suddenly there’s no unemployment… what does the stock market do?


  2. 2 João Marcus Marinho Nunes August 8, 2011 at 9:42 am

    In late 2008 when the monetary “gun” was declared out of ammo by the ones who “held” that “gun” (Bernanke even said that it was “now up to the Treasury”), all ran for the fiscal “gun”. But that particular “gun” tends to jam and even backfire.
    It seems that after the dissapearence of the Soviet Union western countries, US included, decided that “more government” would be a nice thing to have!


  3. 3 David Glasner August 9, 2011 at 7:21 pm

    Morgan, Sorry, but I am not exactly getting your hypothetical.

    “HOW WOULD the ‘market’ respond to an announcement that all public employees (sans soldiers) will be paid 25% less, so that the 16M unemployed can be hired and paid $25K per year?”

    I don’t follow the connection between paying public employees 25% less and what happens to the 16M unemployed. Who is going to hire them for $25K a year?

    Also, I actually don’t like to explain what the market thinks. I only know one thing about what the market thinks, and that only holds, under the current exceptional circumstances: The Stock Market Loves Inflation.

    Marcus, YOu are so right. There is a perfectly good case to be made for allowing the budget deficit to rise during a recession. That is an automatic response for almost any government budget in recession. Revenues fall and expenditures rise automatically, and it would be pointless and counterproductive to try to prevent that natural response of the budget deficit to a recession, a point that the born-again budget balances of today seem blissfully unaware of. But Milton Friedman (albeit in his Keynesian period) understood the point well and never recanted his early views on the subject. In addition, there is very good reason for government to try to shift its infrastructure investment to periods of slack economic activity, because that’s when interest rates and wage rates are relatively low because the private sector is freeing up resources rather than competing for them. I am pretty sure that Hayek, himself, made this point somewhere or other, but I can’t find a citation just now. Unfortunately, Obama, in his early overconfidence, thought he could accomplish much more in this regard than was possible and did not spend the money as wisely as he ought to, and did not pay enough attention to getting the right monetary policy.


  4. 4 Morgan Warstler (@morganwarstler) August 10, 2011 at 9:29 pm

    David, using BLS data if we cut F, S, and Local public employees compensation that frees up the $400B or $25K *16M unemployed.

    The gov could auction them to private employers starting at $1 an hour, or could pay them to dig holes and fill them back up.

    The point of the hypothetical is create no first level of increased aggregate demand, the same amount is being spent by the government on compensation (about $1.7T) yearly. About the same is being spent by consumers – maybe a bit more, since with the cuts to public employees, there’d be less savings.

    BUT SUDDENLY there is no unemployment crisis. There is no screaming liberal sentiment about “unused capacity.”

    We BOTH know the stock market would go ape shit.

    Just not having to listen to Obama moan about the failing of capitalism, or act like he was needed to “do something!”

    My point is THE MARKET KNOWS what is good policy for the market and market based forces.

    Well, wait I won’t speak for you… what do you think happens?

    Please be specific.


  5. 6 David Glasner August 11, 2011 at 11:46 am

    Morgan, Sorry to be difficult, but I don’t know what would happen or have a definite opinion. It is too far beyond my imagination to contemplate. Have you offered the suggestion to any of your more politically well connected pals? Are you using my blog to float a trial balloon? Good luck! It’s good to be on the cutting edge.


  1. 1 Looking at the wrong “gun” | Historinhas Trackback on August 8, 2011 at 10:04 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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