Monday, August 8, 2011

S&P Downgrade: Worse than You Think But Not For the Reasons You Think

While the S&P downgrade of US debt is certainly bad, it's worse than you might think.  Sure, the S&P has a shitty track record of rating debt (just look at their AAA ratings of junk housing bonds for a classic example, which helped trigger the current crisis), but what it signals is something far more insidious. Trevor Greetham, director of asset allocation at Fidelity International opines,
To me the rating agencies are inadvertently helping to poison the global policy response to the private sector debt crisis. Growth is by far the best way to reduce indebtedness but fear of downgrades limits the scope for fiscal action at a time when monetary policy is seriously compromised.

The problem with rating agency and IMF calls for governments to tighten fiscal policy is that monetary policy cannot offset it under current circumstances. We have reached the zero lower bound for interest rates in Japan, the US and UK while quantitative easing in its current form has disappointed.

Central banks have little choice but to print money again at some point in the next few months and this should boost stock prices. But I am not convinced monetary policy can take up the strain if we are seeing fiscal retrenchment at the same time. An expansion of both fiscal and monetary policy offers the best hope for the future. The thought of prolonging and expanding stimulus makes no one comfortable and I too look forward to the day the patient will be off life support. But sometimes increasing medical intervention in the short term is the only way to reach that objective.

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