The US downgrade was merely a symbolic confirmation of what last week’s market panic already made obvious: the next crisis is here.
Last Friday, after a week-long bloodbath in global financial markets, one of the world’s three dominant rating agencies announced that it would downgrade the credit rating of the largest and most powerful capitalist economy in the world. Although expected, it was still a dramatic move drained in symbolism and fraught with unknown repercussions. Still, the downgrade is mere children’s play compared to what still lies ahead.
The world is now staring into the abyss. After a week in which Spain and Italy saw the interest rate on their sovereign debt soar above 6 percent, dangerously close to the level at which Greece, Ireland and Portugal required an EU bailout, and after a week in which the mind-numbing amount of $2.5 trillion was wiped off global stock markets, Standard & Poor’s decided to add the icing on the cake by downgrading the United States’ top-notch triple-A rating.
So what does S&P’s downgrade mean for the United States, for Europe and for the global economy? First of all, it means absolutely nothing. But the problem is that it risks unleashing a self-fulfilling prophecy that will send the world back into recession and push it to the verge of another disastrous global financial crisis — one that will make the last one look like a stroll in the park, and that will threaten the very survival of Western hegemony.
A Pyramid Scheme of Trust
In itself, the downgrade is entirely meaningless. Why the entire world is so transfixed on the simple risk assessment of a small group of dull men in grey suits, remains a great mystery. After all, these were the people who so happily slapped triple-A ratings on subprime-mortage backed securities until days before the collapse of 2008. As Paul Krugman put it, “it’s hard to think of anyone less qualified to pass judgment on America than the rating agencies.”
Furthermore, S&P’s made a whopping $2 trillion miscalculation in the budget overview which it used to justify the downgrade initially. When the US Treasury Department protested, the numbers were revised. But a few hours later, S&P’s simply shifted the rationale for its downgrade from economic to political reasons. Suddenly, it was no longer the US economic outlook that worried S&P’s, but the weakness of its political leadership and economic governance.
Whether one agrees with this assessment or not, it is overtly clear that the downgrade itself was a pre-concocted coup. S&P’s was adamant to push it through, regardless of economic fundamentals. As Dean Baker, Co-Director of the Center for Economic and Policy Research, put it: “there is no coherent explanation that can be given for S&P’s downgrade. This downgrade was not made based on the economics. We can only speculate about the true motive.”
If this is true, why the hell do we still listen to these people? Why do we trust the people who still gave Lehman Brothers a triple-A rating just one month before it collapsed? In truth, the only reason we listen to S&P’s because everyone else listens to S&P’s. And everyone else listens to S&P’s because everyone else listens to S&P’s. The system essentially functions as a pyramid scheme of trust, in which the rating agencies bark and the investor sheep follow.
The problem with finance, however, is that everything is a pyramid of trust. US treasury bills were only considered a risk-free asset, and hence accorded triple-A status, because everyone trusted that the richest and most powerful capitalist economy in the world would simply never default on its loans. This trust, in turn, rested on the assumption that, with the dollar being the global reserve currency, the Fed could always print dollars to ‘inflate’ its way out of debt.
A Crack in the Edifice
This pyramid scheme of trust is now rapidly beginning to unravel. As confidence evaporates from global markets, investors are increasingly beginning to realize that everything they used to believe in was an idea at best and a lie at worst. This realization has very little to do with economic fundamentals. On Friday, the same day that S&P’s downgraded, the US posted some pretty good unemployment statistics. But no one gives a damn about this anymore.
The reason is that investors are no longer looking at the economies they are meant to invest their dollars or euros in, but at the other investors they’re in the trading room with. John Maynard Keynes once put it perfectly when he compared finance to a beauty contest, in which the challenge is not so much to pick the most beautiful face, but to pick what you believe everyone else believes to be the most beautiful face. These are the animal spirits of global finance.
The flaring up of interest rates on Spanish and Italian sovereign debt are part of the exact same phenomenon. Nothing changed in Spain or Italy. Berlusconi has been screwing his country ever since the 1990s, but as long as global financial markets were awash in excess liquidity, international investors were more than happy to finance his gaping budget deficits and contribute to Italy’s soaring sovereign debt, which now stands at a whopping 120 percent of GDP.
Spain’s sovereign debt before the crisis was actually lower than Germany’s. Yes, it’s still sitting on a major asset bubble and a precariously unstable banking system, but the Zapatero government has been exceptionally good at following the orders of the EU and global financial community to cut social spending — to the point where he has largely ignored the 6 to 8.5 million indignant Spaniards who continue to protest against his deeply anti-social austerity measures.
So no, nothing changed in Italy or Spain that would justify the soaring of these interest rates, just as nothing changed in the U.S. to justify the sudden downgrade — Democrats and Republicans still bicker over the exact same issues they’ve been arguing about for the past thirty years: tax and budget increases vs. tax and budget cuts, respectively. (Arguably, the US, with its gaping budget deficits, excessive military spending, outrageous tax cuts, and epic bank bailouts should never have had a triple-A rating in the first place, but this is an entirely different question that was as evident three years ago as it is today.)
So what are we to make of this, then? What does the downgrade really mean? And what will be its consequences? Essentially, the downgrade marks the first crack in the edifice of the global pyramid of trust. The unshakable trust in the dollar as the global reserve currency and the US as an investor safe-haven, is the very apex of that pyramid — the cap stone, if you will, that keeps the scheme from collapsing on itself. When that trust begins to erode, the entire system will start to gravitate towards its center, threatening implode under its own weight.
The Economic Consequences of the Downgrade
Economically, there are signs that things will only get worse. According to CNN Money, “the downgrades from S&P probably aren’t over. It’s likely that S&P will soon downgrade the debt of mortgage finance giants Fannie Mae and Freddie Mac, along with AAA-rated insurance groups.” This will send borrowing costs up for millions of households across the US, raising the threat of a next round of mortgage defaults, resulting in even more collapsing banks.
This comes at a time when growth itself appears to be stagnating. Part of last week’s financial panic was the result of catastrophic US growth statistics, which surprisingly revealed the the recovery virtually flat-lined in the first half of the year. With the multiplier effects of the stimulus package having expired, and with more fiscal contraction ahead, courtesy of the budget fetishists in the Republican party, the US is about to be pulled into another major recession.
As the New York Times wrote, ”a stark reality has come crashing in on both sides of the Atlantic. Neither the United States nor Europe has yet fully recovered from the financial crisis that spread from spring 2007 through early 2009.” The problem is that economic growth never really resumed in the wake of the crisis. Unemployment everywhere still stands at record highs, and consumer spending never really picked up again.
But the greatest threat to the global economy is not the immediate fallout of the downgrade itself. The greatest threat is the implosion of the pyramid of trust in the financial sector. Last week was already the worst week in global stock markets since the depth of the financial crisis of 2008. This week could see even worse losses, and this will prove to be the greatest threat to the global economy. According to the former Bank of England economist David Blanchflower, this “once-in-100-years financial crisis … will take 20 years to adjust to.”
The Financial Consequences of the Downgrade
The optimists have argued that the US downgrade won’t have a very big impact on global financial markets. After all, the US remains the deepest and most liquid bond market, and foreign investors (Chinese, Brazilian, Saudi, German, etc.) still need to put their large capital surpluses somewhere. Since most investors still deem the US to be the safest environment for investment, they will simply ignore the downgrade and things will continue as usual.
One thing we have to stress here is that the people who say this were largely the same people who continued to deny the severity of the last crisis till the very end; same people who said that the credit crunch of 2007 was a mere series of local hick-ups, and that housing prices would never come down simultaneously across the US; same people who said that the first bailout of Greece would solve the European debt crisis, and who just two weeks ago said that the second Greek bailout had been a success. This is not optimism — it’s self-interested cynicism.
In this gloomy climate, we have to be fiercely realistic. For the first time in history, and in a major national humiliation, American debt is now no longer considered risk-free. Whether it’s justified or not, and whether everyone agrees or not, the move will send ripples throughout the global financial system when markets re-open on Monday, threatening to kick-start a disastrous self-fulfilling prophecy of an impending double-dip recession and global financial crisis.
We already got a taste of it today, as Middle Eastern markets, which start trading on Sunday, tumbled across the board. Trading in Tel Aviv was even halted due to mass panic selling. The Israeli stock exchange lost 7 percent today. The fear is that this mass panic in markets will be repeated in Asia and on Wall Street later, and will spread to Europe to destabilize Italy and Spain, endangering the very survival of the euro.
So even if the downgrade was entirely meaningless at heart, traders will give it meaning the moment that markets open on Monday. If last week’s events were any indication, we can safely say that trust had already eroded before the downgrade. The downgrade itself is a mere confirmation that things will only get worse. As the Observer wrote in an editorial on Sunday, “this crisis will run and run, and could make Lehmans look like a Tupperware party.”
The End of US Hegemony?
If this truly materializes, which is now more likely than ever before, this could become what Berkeley’s Barry Eichengreen has called “the mother of all financial crises.” We could see not only the breakup of the euro zone, but also the demise of the dollar as the global reserve currency. Even the normally sober Financial Times now observed that the S&P downgrade risks “creating a long-term threat to the status of the US dollar as the world’s reserve currency.”
What does this mean? Essentially, it will uproot the entire functioning of the global economy. The current role division is very stark: China does all of the work and most of the lending, the US does none of the work and most of the spending. The only thing that has kept this unsustainable arrangement in place, is the capstone of the dollar as the global reserve currency, and the pyramid of trust in US debt as a risk-free investment for global lenders.
So China, which has generated enormous capital surpluses as a result of its spectacular growth levels and brutal wage repression, has subsequently reinvested those surpluses in the US, with full confidence in its status as a risk-free environment. The US, in turn, benefited massively from this arrangement: as long as China kept buying up T-bills, this seigniorage position allowed the Fed to keep printing dollars — and Americans to keep spending them.
In fact, China’s surplus dollars helped fund the Bush wars, the Bush tax cuts and the Bush bank bailouts, which constitute the three principal reasons for America’s overwhelming sovereign debt today. At the same time, many of these surplus dollars flowed into the real estate market and allowed America’s marginalized working class (which has been suffering real wage stagnation for the past three decades) to keep living the illusion of the “American Dream”.
But now, all of that could be reversed. If the US loses its status as ‘seigneur’ in the global economy, in other words, if the dollar loses its status as the global reserve currency, there is no more reason a priori for countries like China, Brazil and Saudi Arabia to reinvest their surpluses in the US. Wall Street will gradually run out of money to play around with, while Washington will run out of money to patch its gaping budget deficits with.
This, in turn, would completely undermine the debt-financed growth model that defined the neoliberal era and that kept American capitalism running for thirty years despite the constant build-up of internal contradictions within the system. As a result, the US will be forced, for the first time in 30 years, to start living within its means. It will no longer be able to suppress social unrest through cheap loans. And it won’t be able to fund its imperial army anymore either.
The consequences of this will be profound. According to Larry Elliot, economics editor of the Guardian, “5 August 2011 will be remembered as the day when US hegemony was lost.” After all, “For the first time, the communists in the east now feel bold enough to tell the capitalists in the west how to run their economies.” In a bizarre twist of fate, the End of History has produced the victory of authoritarian state capitalism over Western liberal democracy.
As the Guardian just put it in a historic sub-header, “US decline leaves China tipped as next economic superpower while pressure on US bonds is set to affect eurozone crisis.” So, as the US slips away, Elliot warns Europeans not to get “too smug about this.” After all, “what we are witnessing is not just the decline of the US but the decline of the west.” We built our pyramid together — and it shall topple on both of us. What we are witnessing is the end of Western hegemony.
So, with traders bracing for a Black Monday, we find ourselves on the eve of what could become the mother of all financial crises. We are now staring into the abyss of 20 years of hegemonic decline and painstaking economic adjustment. Indeed, as Elliot puts it, “we are less than halfway through the crisis that began on 9 August 2007.” Western capitalism has once again brought itself to the edge of a cliff. Time to buckle up folks. It’s only downhill from here.