In August of 2011 when Standard and Poor’s downgraded their rating of US government debt, markets were shocked. The downgrade came on a Friday after the market close, and when the US markets opened the following Monday morning, the three indices fell between 5 and 7 percent over the course of the day. What a reaction.
The ultimate safe haven that day was of course the US dollar, which is the ultimate paradox of financial markets, but funds flew into the very US government bonds that had been downgraded three days prior. Over the past week we witnessed both Moody’s downgrade the sovereign debt of Great Britain, and Fitch issuing warning on debt and lack of budget and entitlement reform in the United States. These are two ostensibly apparent issues, yet the equity markets really seemed to shrug these warnings and downgrades off.
Its seems that the markets have finally grasped the idea of “not fighting the Fed” by continuing to move money back into equities and risk assets in lieu of sitting idle in cash or savings. This is despite what might be some investors concerns over the return of their capital verses the return on their capital. The Organization of Economic Cooperation and Development (OECD), however, offer another opinion for reason why we would not expect a market reaction. They suggest the rating agencies have a “poor track record of sovereign risk pricing over the past twenty years;” furthermore, “any downgrades should be carefully scrutinized, and not taken at face value.” There is plenty of evidence to back up this claim, but the fact that the rating agencies often are late to the party (or in some instances completely miss it) doesn’t mean there is no concern for the alarming debt levels in the worlds advanced economies. Moreover, it is often the case with the complexity of these issues pertaining to sovereign debt, there lies more to the equation than we see.
Latest estimates for the United Kingdom’s Debt-to-GDP ratio are for roughly 81 percent. Though that ratio is much higher as we look across the peripheral Eurozone or perhaps Japan, it is not the ratio itself that worry’s analysts, but the UK’s ability to reign in their debt burden over the next few years. Particular to the UK, and also as an aside is the massive threat their financial sector continues to pose as some estimates have their liabilities at 2.19 times the country’s GDP.
Ultimately though, this has become ‘the debate’ in economics with respect to a nation’s macro economy and what importance should be associated with their debt load. More liberal economists don’t see this number as particularly important because when a country faces recession or slow growth, there are more concerning issues with long term unemployment and workers losing the skills to advance in the work force and develop the economy. The other side to that coin is that by monetizing or inflating a country’s debt only acts to discourage saving and creates a burden for the rest of the economy by only delaying an inevitable problem.
One thing is clear that continuing to finance government expenditures by running continued deficits limits the reach of government and exhausts their ability to successfully stimulate the economy when the next shock hits. We literally have a conundrum with countries like Great Britain or the US because austerity measures need to be imposed to bring balance back to their budgets; however, these draconian cuts have serious consequences for economic growth in the near term, and as witnessed daily, they are both socially and politically unpalatable.
Without manageable debt levels, a central government’s ability to react and respond to crisis is hindered by its over-encumbered promises of the past. Regardless of debt rating agencies raising the red flag, this is an ongoing problem with no clear solution in site.