20111 aug

US Debt Should Be Downgraded – Rip Off This Band-aid

Does anyone remember what caused the financial crises a few years ago? Basically, junk debt was sold as high quality debt largely because rating agencies didn’t do their job, and when the emptiness of that debt became apparent, enormous wealth evaporated.

This sounds familiar in the current crises of US fiscal policy. The definition of a AAA rating on bonds is that they have “virtually no risk of default.”  Does anyone really believe this is true of the US? Debt is approaching 100% of GDP from under 40% just 20 years ago, influential political groups are threatening to choose default over losing their political battles, and our entitlement programs are outrageously unsustainable. While the US has a good chance of recovering from these threats, there is certainly a significant risk of eventual default, and getting away with lying to world markets about this default is a dangerous game.

US debt should be downgraded so that markets can adjust. Piling false credibility on a shaky foundation makes collapse both more likely and more catastrophic. Downgrading US debt now would be painful, but beneficial in the long run. It would force more reasonable diversification of the world’s wealth among commodities and debt markets, and it would force major changes in the US fiscal policy which ultimately could earn a legitimate and sound AAA rating.

I predict the current rating will hold, but purely for political and self-interested reasons of the rating agencies – just as they did with real estate debt in the first decade of this century. When there is no consequence for taking bad risks, markets fail to account for them and debtors fail to to adjust. Ratings exist to measure and communicate risk, not to preserve wealth and stabilize markets. We already saw what happens when they are used for that purpose.

The US should absolutely not default, however S&P and Moody’s should downgrade America’s debt.


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