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A Political Downgrade

If there's no political will for the US to live within its means, its debt cannot be considered triple-A...

SO S&P HAS become the first of the three major ratings agencies to tell the US government its credits aren't any good (or at least not at AS good). It probably won't be the last, says Dan Denning, editor of the Daily Reckoning Australia.

The decision should not have surprised anyone in possession of conscious thought. Divided government — when the Congress and the President cannot agree — is useful for bringing government to a screeching halt. But if there's no real political will in America to begin living within its means, the quality of America's credits must be marked down. 

The nation is simply not as credit worthy as it once was. You can tell by the behavior of its politicians and its central bankers that it does not deserve the privilege of gold-plated credit and management of the world's reserve currency.

The loss of an AAA sovereign credit rating will trigger the re-rating of trillions of Dollars of debt instruments that have their value linked to US government bonds. And the de-facto loss of reserve currency status will accelerate the move by investors to diversify their portfolios into other currencies.

Don't expect the downgrade to trigger a sell-off in US bonds. "There is no change in Japan's trust in US bonds," a senior Japanese official told Reuters. The US Treasury market is the deepest and most liquid fixed income market in the world. Even if it's poisoned, investors will still drink from it. It's the only pool of capital large enough to accommodate a very large herd of terrified global investors.

Strangely, then, even though the US credit rating has been downgraded, expect to see investors flock to Treasury bonds and notes. They will sell "riskier assets" and buy liquid "safe" assets. Gold futures are up 2.5% as we write and just shy of US$1,700.

By the way, S&P said the long-term fiscal path of the US is a giant collision with reality that's bound to happen. The US Treasury Department disputed S&P's conclusions and said the ratings agency screwed up on its calculations by a few trillion bucks. But S&P fired back and replied that estimates of debt-to-GDP ratios were not the core motivator for its decision. So what was? S&P wrote:

The political brinkmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy.

So there's "political risk" to investing in American bonds now. This goes hand-in-hand with the US Dollar losing its status as the world's reserve currency. S&P realizes that no one in Washington takes those developments seriously. Or, that the lack of agreement on what to do about America's debt problem means America is simply not as credit worthy as she once was. Who can really argue with that?

The downgrade must have come as bittersweet news to America's largest trading partner in crime, China. China owns $1.2 trillion worth of US bonds and notes. And China sits on $3.2 trillion in foreign-exchange reserves, many of which are in US Dollars. The value of US credits and the stability of the Dollar are the key issues in the world's most important economic relationship.

Like a loving but firm spouse, China has taken the news and issued some hard words for America. An editorial at state-media outlet Xinhua gives the following relationship advice to America's politicians:

The US government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone.

China, the largest creditor of the world's sole superpower, has every right now to demand the United States address its structural debt problems and ensure the safety of China's Dollar assets.

International supervision over the issue of US Dollars should be introduced and a new, stable and secured global reserve currency may also be an option to avert a catastrophe caused by any single country. We have to recognize that the world has entered a global financial crisis that concerns all countries.

The trouble is, there is no stable and secure global reserve currency this morning, unless you count gold. The conventional wisdom is that the world could move from a Dollar standard to a "something else" standard with very little disruption. This week will be a good test of that wisdom.

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Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles

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