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Unpopular Rating

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On Monday 18 April, when Standard & Poor's (S&P) sent out a warning about the unsustainable fiscal deficit and the growing public debt of the US government and threatened to lower its rating, reactions were mixed. Financial markets were surprised; over the past few months, Eurozone debt has been widely discussed. Even Japan's fiscal position has caused some worry. US stockmarkets declined sharply on Tuesday, shrugged off the effects of the possible downgrade on Wednesday, and went back to normal after that. Some economists have even laughed at the S&P report.
S&P's rating review expressed concern over the "US's meaningful economic and fiscal risks and large external debtor position". From 2003 to 2008, the fiscal deficit varied between 3 and 5 per cent. Following the global credit crisis, the fiscal deficit is 11 per cent of GDP. The failure of US President Barack Obama and the Congress to reach an agreement on a meaningful fiscal consolidation strategy appears to have prompted S&P's rating review.

But how serious are the problems of the US external debt and the worsening fiscal profile? Media commentators have lamented that most US debt is held by foreigners, and in the Congress, legislators have called for harsh measures to push fiscal consolidation and spending cuts.
Most Asian countries — China in particular — hold a large amount of reserves in dollar-denominated Treasury securities, a reflection of China's trade surplus with the US. There has been much talk about correcting these imbalances, but not much action has resulted. If the US were to replace Chinese exports with domestic goods, employment would rise dramatically, as would tax receipts and GDP growth. The debt-to-GDP ratio would take care of itself. But it is hard to imagine cheap Chinese labour contracting so easily.

It is not clear that deep spending cuts would help fiscal consolidation very much either. When Japan tried that in 1997, the debt-to-GDP ratio got worse: lower government spending meant lower GDP, and since public debt does not decline at the same speed, the macroeconomic situation deteriorated even further. More recently, spending cuts in Ireland and Latvia produced the same results.

Recent academic research seems to support the idea that spending cuts make things worse. A paper by Victoria Chick of the University of London and Ann Pettifor — Fiscal Consolidation: Lessons from a Century of Macroeconomic Statistics — showed that 10 attempts at fiscal consolidation through spending cuts in the past 100 years all failed to improve debt-to-GDP ratios.

The S&P report has something disturbing. Page 4 of the review has this sentence: "...the risks from the US financial sector is higher than we considered them to be before 2008…"

S&P believes that risk in the US financial sector are rising. Is another crisis — as many doomsayers have warned — looming on the horizon? Sceptics dismiss the idea: the credibility of rating agencies is questionable after the crisis. 

It is a cross S&P will have to bear for some time. 

(This story was published in Businessworld Issue Dated 02-05-2011)