Monday, 15 August 2011
World without the risk-free bench mark…
Last week’s S&P’s downgrade of US debt undoubtedly marked a new chapter in the history of the recent crisis. Double-dip recession is no longer a mere possibility, but a sad reality. Extensive use of fiscal and monetary policies, otherwise known as Quantitative Easing, was implemented by the Fed and ECB to battle against the meltdown of the financial system in 2008. But, by driving the interest rates to near to zero levels, the developed world locked itself in the liquidity trap, while soaring debt levels stripped the governments of the ability to use fiscal policy if the recession returned. The Debt crisis became a new malaise in the developed world, which caused a fall of investors’ confidence in the strength of political institutions and their ability to deliver quick and much needed anti-recession solutions. S&P used weakening of political leadership as their main reason for the US downgrade, an event which caused massive market sell offs last week.
So what effect might the US downgrade have on the economy, other than from the need to rewrite hundreds of thousands of economic text books to correct for the absence of the risk-free bench mark? Market uncertainty and increased volatility had already been reflected in recent panics which caused share sell offs all around the world. As for the average consumer, a cut in debt rating usually results in higher interest rates paid on mortgages, car loans etc, as they are linked in the short term. However, some suggest that a mistake in S&P calculations by almost $2 trillion(!), and their worries about the US political strength and not the country’s creditworthiness will make investors even more unsure who to believe. Thus the most immediate effect is the increase in the uncertainty premium needed to compensate investors for holding US Treasuries. We should really start getting worried if the other two major rating agencies (Moody’s and Fitch) follow the steps of S&P, which will only make the panic worse. But for now, what S&P did goes against vital economic assumption- they deprived investors of beloved ‘risk-free’ assets, leaving them hanging without a safety net.
Written by Daria Rusanova - 4th year MA (Hons) Economics and Economic History