Blaming the Referee

Over the past couple of days a number of politicians have jumped into attack S&P for their decision to downgrade United States sovereign debt. The main theme in these attacks has been that S&P missed sub-prime and therefore lacks credibility. However, it is interesting that the people who have been doing the criticizing have had just as poor records with regards to the financial crisis of 2008.

Yesterday in an exclusive interview with CNBC, Timothy Geithner said, “S&P has shown really terrible judgment and they’ve handled themselves very poorly”. In order to further diminish the credibility of their decision he said “just look at the quality of judgements they’ve made in the past”

Paul Krugman was equally irate with the decision. He claimed that S&P lacks credibility and showed an amazing amount of chutzpah to downgrade the debt. On top of their having missed subprime, he uses the example of Japan to prove how they have been wrong in the past as well in similar circumstances.

He wrote, “And in those rare cases where rating agencies have downgraded countries that, like America now, still had the confidence of investors, they have consistently been wrong. Consider, in particular, the case of Japan, which S.& P. downgraded back in 2002. Well, nine years later Japan is still able to borrow freely and cheaply.”

Krugman, however, is ignoring the fact that a downgrade is not a prediction by a rating agency that a country will default. When S&P cut Japans rating they weren’t making a prediction that Japan was going to default and were thereby proved wrong when Japan remained solvent. S&P’s definition of a AA rating is “AA: An obligor rated ‘AA’ has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree.” So S&P was RIGHT when they predicted that Japan had a strong capacity to meet their debt obligations and they did. Japan though has enormous debt – over 200% ratio to GDP – some say the highest in the world. It seems pretty reasonable that S&P wouldn’t assign them the highest possible rating, reserved for only the most fiscally responsible countries.

After Krugman rants about S&Ps decision he goes on to admit that the US does have serious problems: “And yet America does have big problems. No, what makes America look unreliable isn’t budget math, it’s politics. And please, let’s not have the usual declarations that both sides are at fault. Our problems are almost entirely one-sided — specifically, they’re caused by the rise of an extremist right that is prepared to create repeated crises rather than give an inch on its demands.”

Political uncertainty is one of S&P’s main criteria with regard to Sovereign debt, so Krugman actually makes a strong argument for the AA+ rating. While he thinks the finances are strong, he thinks there is concern with the political climate. That seems exactly sufficient to merit a AA+ rating as the AA+ rating only differs from the AAA in that it encompasses a slight uncertainty.

Geithner too talked about problems with the fiscal picture. He said, “There’s no surprise that the U.S. has a long-term and unsustainable fiscal position,” he said. “We believe that. The president believes that. That’s why he’s been fighting so hard to bring people together to try to deal with it.” Given that both men admit that there is at least some challenges and uncertainty a AA+ rating seems more than reasonable and even a bit generous.

I thought the most amazing thing though was that both men challenged the credibility of S&P based on the subprime crisis. Surprising because Krugman and Geithner have both had pretty weak credibility with regards to the crisis as well.

In fact during the formative years of the housing bubble when the Fed was still lowering interest rates, Krugman said in an interview. “During phases of weak growth there are always those who say that lower interest rates will not help. They overlook the fact that low interest rates act through several channels. For instance, more housing is built, which expands the building sector. You must ask the opposite question: why in the world shouldn’t you lower interest rates?”
Excessively low interest rates is widely agreed to be one of the main causes of the crisis.

Geithner was also equally poor in his predictions of sub-prime. Before becoming Treasury Secretary, Geithner was the president of the Federal Reserve Bank of New York. He voted with Bernanke and consistently agreed with the general consensus of the Federal Reserve whose Chair (Bernanke) was still laughing off the idea that the housing market was in a bubble even in the later years of the bubble.

Krugman and Geithner came off as hypocritical and in denial. To use a sports analogy, they reminded me of the types of athletes who blame the referees after a loss. It’s the S&P’s job like a referee to make an impartial analysis and judgement and there is no real reason to believe that they are not doing anything but their best to provide objective analysis. Krugman and Geithner could have come out and said the S&P decision was fair and reflects the fact that while we are still a very solid country, the AA+ rating acknowledges that we have some political and long term fiscal sustainability problems. Nonetheless, we plan to work our hardest to regain the AAA rating. They could have accepted the loss of AAA status with a bit of integrity, instead they whined and blamed the refs.

The New Central Bankers Dilemma

When I penned the song Central Bankers Dilemma in the summer of 2008, I was writing about the dilemma a central banker faces during a period of stagflation. When a central banker raises interest rates he constrains growth and when he lowers interest rates it exacerbates the inflation problem. Recently Japan and Switzerland engaged in expansionary monetary policy but not to stimulate their economy but rather to stem their currencies from appreciating more. Today central bankers have a new problem of how to deal in a world where developed countries have ultra stimulative monetary policy. When the United States keeps its overnight rate at roughly 0% it is very hard to raise interest rates without having your currency appreciate. Countries like Canada and Swtizerland whose economies have fared fairly well have had to maintain lower than normal interest rates to prevent a rapid appreciation of their currency. Canada has kept its overnight interest rate at 1% despite a reasonably robust economy. Luckily, Switzerland and Canada can do this without worrying too much about inflation. Unfortunately for some developing countries that is not the case.

In Brazil, interest rates are already extremely high – the overnight rate is roughly 12%. However, even despite the high interest rates, growth and inflation are both above trend. In Brazil’s case it would seem obvious that they should raise interest rates even more to cool off inflation and growth. However, in a world where other countries have nearly 0% interest rates, further moves to tighten monetary policy will make the Real even stronger. Since December the Real has already gained 10% on the dollar and has already made it very difficult for exporters. From a personal level, it is clear to me that the Real is already overvalued when I travel to countries like Argentina and the same things cost less than half the price. This marked difference is especially difficult to understand when Argentina is actually a more developed country than Brazil (based on GDP per Capita).

So the Central bankers dilemma for developing countries like Brazil is whether to raise interest rates and risk a further appreciation in the currency or to lower interest rates and risk even greater inflation. Sounds like a great subject matter for a song!

Talk with David Rosenberg

I recently had the pleasure of talking with David Rosenberg, chief economist at Gluskin and Sheff and we talked about some of his impressions on the economics behind several of the songs on Recession Sessions .

Greenspan’s Defense
Rosenberg is no defender of the Maestro, and gave the legendary Central Banker a very poor grade. He also made clear to differentiate between the easy money policies of Greenspan and Bernanke. Rosenberg told me, “If you Gave Bernanke an economy that was growing at 5% – he certainly would not have kept rates that low for so long.” Rosenberg feeling was that at least Bernanke can pin his ultra-loose monetary policy on a weak economy, whereas, Greenspan had no such excuse.

This Time Around (Song about the Canadian Economy)
Rosenberg is still fairly bullish on the Canadian economy. Canadian banks have strong balance sheets, the fiscal situation is relatively better than other developed countries and the Canadian economy benefits from a recent strengthening in commodity prices. That being said, he doesn’t think that the Canadian fiscal situation is very solid either. He used the expression, “in the land of the blind, the one-eyed man is king” to sum up Canada’s fiscal situation. He understands the American economy to be 20 years behind the Canadian economy right now in terms of dealing with a serious fiscal situation.

Gold Price Factors
There was a story a month ago when George Soros sold most of his gold holdings that gold could be in a bubble.
Rosenberg’s opinion was that Gold is not even experiencing a mania let alone a bubble. He said that if you normalize the price of gold by the money supply that you don’t have a bubble at all. A bubble would start to emerge at around 3000 dollars an ounce.
He says, that gold is trading more like a currency now and less like a commodity.

Is it over yet?
Is it over yet was Rosenberg’s favourite song on the album.
His answer to the question was a resounding NO.
The global economy still faces major risks. The biggest of which are the European Debt crisis, the Japanese economy and the US economy which also faces major headwinds. However, he was not completely gloomy about the US. He added to his claim that, “The United States has immense wealth and they have a knack for getting their act together.”

Let’s hope they can do it again this time before the August 3rd deadline to raise the debt limit.