Monday, Jun 24, 2024

US Credit Rating Downgrade Underlines Double Dip Fears

The loss of the triple-A credit rating which has been enjoyed by US government securities for the past 70 years, by rating agency Standard & Poor's, was another blow to a reeling US economy. It was the most serious consequence so far of this summer's political gridlock over the debt ceiling extension bill, and the inability of Obama and congress to reach an agreement on a far-reaching plan to bring down future budget deficits. The prospect of an immediate technical default through the US government was averted by the last minute passage by Congress of a debt ceiling extension on August 2nd, the day the Treasury warned that it would run out of money to pay all of its bills. The long term issue of how to reduce future deficits was deferred until November, when the issue will be taken up by a special 12-member bipartisan Congressional committee with extraordinary authority to force an up or down vote on its recommendations before the end of this year. This agreement was sufficient for two other credit rating agencies to defer any action to reduce the US credit, until it is clear whether the congressional committee plan wins approval in December. However, Standard & Poor's dropped the ranking one level after warning on July 14 that it would reduce the rating in the absence of a "credible" plan to lower deficits, even though the immediate threat of reaching the debt limit was avoided.

‘The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics,” S&P said in a statement announcing the ratings cut. John Chambers, chairman of S&P’s sovereign rating committee, said that a $4 trillion debt reduction plan would be the minimum needed to “signal the seriousness of policy makers to address the fiscal situation” and allow the US to retain the triple-A credit rating. The deal signed into law by Obama cut only $917 billion from budget deficit estimates.


The move immediately triggered political recriminations with both Republicans and Democrats blaming one another for the inability to retain the triple-A rating. The rating downgrade was seen as a serious psychological blow to the longtime US position as the strongest economy in the world.




Concern over the near term health of American and European economies has been rising. The outlook in the US has been clouded by weakening economic statistics, along with the largely political dispute over the debt ceiling and the proper solution to the deficit spending problem. These were further complicated by renewed concern over the extent of European sovereign debt problems now affecting Italy and Spain. The combination of those fears and uncertainties prompted wild swings in Wall Street stock prices. The result last week was a 700 point loss in the Dow Jones Industrial average, the largest point decline since the panic triggered by the October, 2008 financial crisis. All this happened before Standard & Poor’s issued its credit downgrade.


Both Obama and Republicans leaders had expressed concern over the possibility of a credit downgrade should the debt ceiling crisis not have been resolved by the August 2nd deadline.




The dispute was based upon a fundamental difference in the Republican and Democrat approaches to the problem. The Republican view was that the core of the problem was runaway big government spending, and a refusal by liberals to allow the necessary long-term reforms in entitlement programs such as Medicare and Social Security, to bring their costs down to manageable levels.


The Obama administration, however, views entitlement programs as sacrosanct, and insisted that spending cuts must be accompanied by substantial tax increases on businesses and high income earners. But even according to the administration’s own estimates, tax increases would not be large enough to make even a significant dent in the problem.


Republicans, on the other hand, view the liberal Democrat “soak-the-rich” approach to the problem as counterproductive, reducing the incentive to create more jobs and ultimately hurting prospects for a vigorous recovery. Their approach to the problem calls for steep cuts in spending and modifications to entitlement programs. One example is the budget proposed by Republican Paul Ryan, chairman of the House Budget committee. Republicans also want a thorough reform and simplification of the federal tax code. That would result in lower tax rates for everyone, while generating more tax income by eliminating many of the special interest tax breaks and deductions which have been added over the past 25 years.


That debate will be played out once again in the bipartisan committee’s deliberations over further deficit spending reductions in November, and certainly in next year’s election campaign. But in the meantime, there is a downsized expectation for the growth of the American economy in coming months, and a real danger of a double dip recession. That reduced outlook will also impact the immediate economic prospects of tens of millions of American families.




A steady stream of sobering government figures documenting the slowdown of the American economy changed the consensus among many market experts about the underlying strength of the economic recovery which began in 2009. The current thinking is that the recovery came to a near standstill in the first quarter of 2011, and is now proceeding so slowly that any unexpected additional economic shock could stall it completely. The anemic 1.3% growth rate for the second quarter, which is only a small improvement over the nearly flat 0.4% rate for the first quarter, means that the unemployment rate is unlikely to fall much below 9% before the end of the year. Some economists are predicting that if growth remains at or near current levels, the unemployment rate may increase before the end of the year instead of improving.




At one point last week, rampant pessimism almost totally took over the market’s mentality. Following the disappointing job growth numbers in June, there was widespread fear that July would yield flat or even negative job growth. That led to a more than 500 point loss in the Dow Jones Average Thursday, August 4.


In fact, the July figures showed a slightly improved level of job creation, and there was an upward revision of the June numbers as well. Nevertheless, average monthly job growth for the second quarter was only half the rate at the beginning of the year, and still short of the rate necessary to absorb new members of the labor force, let alone provide jobs for the millions of Americans who have been searching for work for more than a year, or even two.


Another disappointing sign hidden within the July job numbers is the fact that more workers have given up their job search, which explains the drop in the national jobless rate for that month from 9.2% to 9.1%. Another complication is the statistical adjustment made to the jobless numbers to account for seasonal factors. In July, this included the assumption that over a million school teachers were temporarily removed from the payrolls for summer vacation. This is why economists say that it can be misleading to assign too much importance to a single month’s job statistics. However, the job creation average over a full quarter is much more reliable, and those statistics clearly indicate an economic recovery that is, at best, sputtering.




Nevertheless, the fact that the July job growth numbers were not as bad as expected led to a brief surge in stock prices when the market opened Friday. That was quickly reversed by fresh fears that the European sovereign debt crisis was again threatening to spiral out of control


While the threat to European banks holding bonds issued by Greece and other weak European economies has been largely addressed by European Central Bank bond repurchase programs, there were fresh fears raised in the financial markets Friday about the ability of Spain and Italy to recycle their sovereign debt which is coming due within the next few months.


In less than three hours, the Dow Jones Average plunged by more than 400 points, before a report from Europe indicating a possible bailout plan for Italy reversed those losses in less than an hour. The market closed 3 hours later up 60 points for the day, or about half a percentage point, but the wild ride left traders breathless and fearful about what might come next.




They didn’t have to wait long. A few hours after the market closed Friday, the Standard & Poor’s credit rating service made good on its threat to downgrade the AAA rating on long term US securities by one notch to double A plus.


The impact of the S&P action is not clear, because the two other credit ratings agencies, Moody’s Investors Service and Fitch Ratings confirmed their AAA credit ratings for US government securities.


Administration officials publicly criticized Standard & Poor’s action, suggesting that it was politically motivated rather than based on the actual creditworthiness of government securities.


The Treasury Department quickly called attention to a $2 trillion discrepancy in the financial projections which S&P issued with the announcement of the downgrade, but the rating agency stuck by its action, even while acknowledging the computational error.


Critics were quick to suggest that S&P was playing politics with its credit rating, noting that the agency is now under the control of federal regulators. The reliability of S&P’s ratings is also suspect because it badly misled investors by endorsing the quality of risky mortgage-backed securities issued by the big banks and Wall Street firms, which ultimately led to the 2008 financial crisis.


How much the S&P credit downgrade action will affect government borrowing costs and investors with significant quantities of government securities in their portfolios remains to be seen. But its greatest effect is likely to be the further damage it has caused to the international image of the US government and the status of the US dollar and federal securities as the safest financial investments in the world.


The appropriate credit rating of US securities is a related but separate issue from the debt ceiling crisis, which is primarily a political issue, and the current weakness of the US and world economies, which is seen as having grown more serious since the start of this year.




Part of the economic problem is that there is no prospect anywhere of any new sources of business investment or consumer demand which could shake the stalling US recovery out of its current doldrums.


As a result, leading economists are downsizing predictions for growth in the second half of this year to the 2%-3% range, and US businesses are scaling back their production and sales projections accordingly.


Given the disappointing results of Obama’s 2009 stimulus program, and the current negative attitude in Congress toward all new deficit spending initiatives, passage of another stimulus package would appear to be out of the question.


The Federal Reserve’s QE2 stimulus program, which injected $600 billion into the economy by buying government securities, has just been completed, but Fed chairman Ben Bernanke must now be more careful about launching another bond purchase program to stimulate the economy. Some attribute the recent rise in gasoline prices to more than $4 per gallon at least partially to QE2, and claim that the negative impact of the resulting higher gasoline prices on consumer spending resulted in an overall negative for the US economy.


No help can be expected from increasing US exports foreign countries either.




This is very bad news for Obama and the Democrats. They will face the voters next year with a national unemployment rate still well above 8%, widely considered to be a politically toxic level for a president seeking re-election.


Beyond the political implications, recent economic numbers have led some experts to conclude that the lingering effects of the 2008 market meltdown and the collapse of the real estate market, combined with the disappointing failure to replace millions of lost jobs, means that the economy has been fundamentally damaged, and has lost the resilience which has characterized its recoveries from other recessions over the past quarter century.




Since the late 1980s, the ups and downs of the American economy have largely been muted due in part to the enhanced ability of the nation’s political and economic leaders to moderate the forces which drive inflation and the traditional business cycle. By manipulating interest rates and fiscal policy, government policy makers could smooth out the peaks and valleys in the business cycle, resulting in long periods of steady and sustainable growth. But according to Harvard economist James Stock, the volatility of economic output, income and consumption today looks more like it did 25 years ago. “In this recession and its aftermath, those smoothing mechanisms, those shock absorbers, clearly have been damaged,” he says.


This view stands in contrast to those of analysts who have given all kinds of excuses for the disappointing performance of the US economy in the first half of this year, ranging from the harsh winter weather, to industrial supply disruptions due to the earthquake and tsunami which hit Japan, to sharply higher gasoline prices. But none of these transitory factors can hide the fact that we are now in the midst of one of the weakest economic recoveries since World War II, with the real possibility of any further bad news triggering a long-feared double-dip recession.




The reasons for the slow growth are not hard to find. Consumers lack the confidence needed to increase demand. In the face of a very difficult job market, they are still paying down debt and conserving cash, rather than making any major new discretionary purchases. As a result, US consumer spending, adjusted for inflation, fell in April and May, and has remained extremely weak since then.


After a decade of living on borrowed money, much of which was financed by overinflated housing prices, average US household debt levels remain at 112% of annual income, which is far higher than the average debt-to-income ratio of 84% during the 1990’s. Thus, expect continued weak consumer demand until household debt levels return to more sustainable levels.


Many American consumers have lost hope that they will be better off financially in a year than they are now. A decade ago, even just after the Sept. 11 terror attacks, 45% of Americans who were asked that question answered it optimistically. This past February, only 30% said they expected to be better off financially in a year; and in July, the percentage of those with an optimistic view of their economic futures was just 20%, an all-time low.




Stubbornly high rates of long term unemployment have further aggravated the plight of many of these families. One example is the situation of Pat Sonnek, 50 years old, of Gibbon, Minn,. who lost his high-paying job programming mainframe computers five years ago. Realizing that he could not get another job in computers, he earned an online degree, learned accounting, and took cash out of the accumulated equity in his home to help make ends meet during the transition.


Today he has a $110,000 mortgage to pay off on a home that is worth less than that, and $80,000 in student loans coming due. He is making $36,000 a year as an accountant for a small retailer, less than half the $80,000 he made in his computer programming job. He commutes 55 miles to work every day, which means that rising gas prices “hit pretty hard.”


To economize on their living costs, he and his wife, who has a part-time job as a school custodian, have gotten rid of their landline telephone, canceled their cable service and buy fewer fresh fruits and vegetables. “I’m running out of things to cut,” he says, adding that if he needed a few thousand dollars to meet an emergency, “I’d have to go begging to friends and family.”


The Sonneks are not alone. Robert Hall, a Stanford University economist, finds that three-quarters of US households don’t have two months worth of income available as cash or other liquid assets. Federal Reserve researcher Karen Pence finds that 41% of US households have less than $3,000 left on their credit cards and 23% have been turned down or discouraged from applying for credit.




Middle age workers like Sonnek, including those with extensive professional experience, often find themselves in the most difficult position when competing with younger workers for available jobs. In the most recent recession, highly paid and geographically settled middle-aged workers were among the first fired and are among the last to find new jobs, because when companies begin hiring again, they rarely hire back as many middle-aged workers as they laid off.


“Fathers are losing their jobs, and their sons are taking them,” said Mark Zandi, chief economist at Moody’s Analytics, which found that workers between the ages of 35-54 are having the toughest time replacing their lost jobs. “Meanwhile, the proportion of older workers is rising because they’re holding onto jobs longer to make up for financial losses in the recession.”


This disparity in hiring reflects a number of labor-market trends that favor lower-paid and highly mobile young workers at one end of the age spectrum and experienced older workers willing to accept lower wages for flexible schedules at the other end. Job-placement specialists say some companies have turned to workers over 55 because they are more willing to accept short term contract positions and, in some cases, have their own medical insurance from previous employers or from Medicare. That makes them less expensive to hire than middle-aged workers.


In addition, middle-aged workers often have school-age children, making it more difficult for them to follow a new job prospect to another part of the country. Others, who may be willing to move for their new job, find that they cannot afford to because that would require them to sell their current home at a loss.




Housing prices are still plunging in most areas of the country, resulting in more underwater mortgages and abandoned homes coming on the market.


Stricter credit standards to qualify for a new mortgage to buy a home, combined with a high pace of evictions of homeowners who have fallen behind on their monthly payments, pushed the second-quarter of 2011 US homeownership rate down to 65.9%, the lowest level since 1998.


Home ownership reached a record high of 69.2 percent in 2004, as a result of lax mortgage credit standards put in place during the Clinton era that encouraged low income families to purchase homes that they could not really afford to pay for. The loose standards prompted others to engage in real estate speculation that helped drive up home prices to unsustainable levels. This led to the real estate price bubble and crash which has still not fully run its course.




The situation has gotten so bad in some parts of the country, that Bank of America and other large banks which are stuck with abandoned homes they can’t sell, are paying to tear them down just to get them off the real estate market.


Bank of America has announced that it will donate 100 foreclosed houses in the Cleveland area and contribute to their demolition in partnership with a local agency that manages blighted property. The bank has similar plans for 100 properties in Detroit and 150 Chicago. Wells Fargo, Citigroup, JPMorgan Chase and Fannie Mae are considering or implementing their own versions of the same programs.


The properties involved are in varying states of disrepair, and are generally considered not worth the cost of repairing them. In those cases, it costs Bank of America less to donate the properties to charity and contribute to their demolition than to continue paying property taxes on them while trying, in vain, to sell them, even at a loss.




Millions of unemployed or underemployed homeowners who bought their homes near the top of the real estate market now find themselves stuck, unable to take advantage of job offers elsewhere in the country, because they would have to try to sell their current homes at a steep loss to move their families.


Trussbilt LLC, a company which makes security products for correctional facilities, has been trying to hire workers for its plant in Huron, South Dakota, where the local unemployment rate is less than 5%. In August 2008, it recruited about a dozen workers from Elkhart, Indiana, where unemployment was at 9% and rising. But since then, all of those workers have returned to Indiana because they were tied to families who couldn’t move and homes they couldn’t sell.


According to the Census Bureau, a decade ago, 4.5 million American households moved to a new community due to a new job or job transfer. In 2009, with housing prices dropping sharply, that number was down to 2.9 million households.


Two of the main economic engines which have driven growth in recent recoveries are now absent. The glut of unsold housing is actually holding back the recovery and consumer demand is virtually flat.


This is why this recovery, which is now two years old, has failed to pick up steam as expected, despite strong overseas demand for US goods, and record US corporate profits.




Meanwhile, the ability of the government to stimulate a recovery has been eliminated.


In 2003, when an economic recovery stumbled, the Bush administration was able to prop it up by passing tax cuts to get cash into the hands of consumers, while the Federal Reserve pushed down interest rates to make it easier for consumers and businesses to borrow. In the recession of 2008- 2009, the Obama administration and the Federal Reserve did it again, with an $800-billion stimulus package and by cutting interest rates to near zero. But now, those options are no longer available.




As the current recovery stalls, the federal government is unable to respond. In fact, the required cuts in government spending to bring the deficit down will have a slightly negative immediate impact on the GDP. Government spending overall is already falling on the federal state and local levels.


Conservative economists argue that reductions in government spending and the deficit will ultimately strengthen the American economy by freeing up more capital for productive investment and job creation by the private sector. But in the short term, it will take its toll on agencies and private firms whose payrolls and contracts will be cut, as wasteful or unnecessary government spending is eliminated.


Meanwhile, the financial markets are still trying to absorb the implications of the lowered estimates of first and second quarter growth. Weak first quarter growth fell 1.5% short of the previous estimate, and the first official estimate of second quarter growth came in 0.4% lower than had been expected, with further revisions possible in the months ahead.




These weak GDP growth numbers are the real explanation for the feeble pace of job growth in recent months. Consumer spending, which normally accounts for 70% of US economic activity, grew at a near-flat 0.1% in the second quarter of this year.


The slowdown in consumer demand has now starting to impact the plans of American businesses which had been expanding in the expectation of strong consumer growth in the second half of this year.


There is a growing crisis of confidence in the US economy. Business leaders are afraid to create new jobs in the expectation of new taxes and government regulations from the White House.


Obama and his economic team are out of ideas, and unwilling to even consider the Republican approach to the problem which has arisen directly from the demands of voters expressed in the voting booth last November.




Americans have made it clear that they are tired of big spending stimulus programs that have failed to generate the promised stimulus, and out-of-control government spending which will take decades for our children and grandchildren to pay off to foreign lenders.


But Obama and the Democrats have still not acknowledged that message from the American people. Job killing taxes, soaking the rich and class warfare rhetoric are not the answer to this country’s economic problems.


Obama missed a golden opportunity to start attacking the core of the problem, and improve prospects for his re-election at the same time, when he rejected bold Republican compromise proposals to resolve the debt ceiling issue last month. That may have been his last chance.




Walking the Walk Have you ever had the experience of recognizing someone in the distance simply by the way they walk? I have, many times.

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