Home > The Economy > The S&P downgrade market plunge myth

The S&P downgrade market plunge myth

from Dean Baker

The Wall Street crew that wants to cut your Social Security and Medicare benefits are sensing that victory is in sight. They have managed to knock jobs completely off the agenda and have made deficit reduction the near-exclusive focus of economic policy in Washington. They are now setting the stage to have the Congressional “super-committee” produce a deal that will mean large cuts in both programs.  The backdrop for these cuts is that the country is in crisis and that we have no choice. A central part of this story is that the stock market crashed last week in response to the Standard and Poor’s downgrade of U.S. government debt. The Wall Street crew and their allies in the media and Congress will tell the country that if we don’t have the cuts in Social Security and Medicare demanded by S&P then we run the risk of further downgrades. This raises the prospect of further market panics and the complete wreckage of the economy.

This story has as much credibility as John Edwards’ tales of marital bliss during his presidential campaign. First, every informed investor knows S&P’s sterling track record of missing everything in sight. It gave top investment grade ratings to hundreds of billions of dollars of subprime mortgage-backed securities, to Lehman until its bankruptcy, to AIG until its collapse, to Enron until just before its collapse. They know about its $2 trillion arithmetic error in assessing U.S. indebtedness.

They also know that S&P, like the other credit rating companies, is very concerned about the final wording of rules that are being written as part of the Dodd-Frank financial reform bill. That is why it is far more likely that the downgrade was done with the hope of currying favor from powerful political figures than out of the belief that the government will be unable to pay its debt.

This is why the markets completely laughed off the S&P downgrade. Yes, the markets completely laughed off the S&P downgrade. Let’s say that a third time just so that even a Washington Post editor can understand it: the markets laughed off the S&P downgrade.

The S&P downgrade was supposed to mean that it is now more likely that the U.S. government will not be able to pay its debt than previously believed. If the markets took this warning seriously then they would attach a higher risk premium to U.S. government bonds.  That would mean that bonds would fall in price and the interest rate on government debt would rise.

But the exact opposite happened. U.S. government bonds soared in price. The interest rate on Treasury bonds plummeted to less than 2.2 percent, near-record lows. In other words, investors voted with money as loudly as possible that they view U.S. government debt as a very safe asset and that the S&P crew doesn’t have a clue.

There is an obvious alternative explanation for the stock market plunge which also explains the flight to government debt. The euro zone’s debt crisis spread from relatively small countries like Greece and Ireland to the euro zone giants, Spain and Italy. If these countries defaulted on their debt it would almost certainly lead to the collapse of several major European banks.

This in turn could lead to the sort of financial freeze-up that we saw after the collapse of Lehman in the fall of 2008. This would mean another economic free-fall with the economy shedding millions of jobs as normal financial flows were blocked.

The euro zone collapse scenario is genuinely frightening and can easily explain why the markets would be panicked. But the moral of the euro collapse story is to get competent people running the European Central Bank who can prevent this sort of crisis. Cutting Social Security and Medicare will not save the euro.

However the Wall Street crew knows that most people do not follow the economy and finances closely. So they just made up a bogus story with the hope that the country would buy it. Thus far they have already gotten politicians and reporters to push their line that the debt downgrade led to the stock market plunge.

Needless to say, those pushing for cuts in Social Security and Medicare will freely use the story of the downgrade market plunge to advance their agenda without fear of ridicule from the media. As a result, we can expect a continual parade of public figures saying that we need big cuts in these programs in order to prevent another market crash and economic collapse.

If these programs are to be protected, it is essential that the public provide the missing ridicule. Any politician who has so little understanding of financial markets and the economy to blame the stock market plunge on the downgrade should not be involved in designing economic policy. Any reporter or columnist who makes such a connection should be in a different line of work.

People who understand economics know that Social Security and Medicare have nothing to do with the country’s economic problems. Unfortunately such people have been virtually excluded from the national economic debate by the people with money who want to undermine these programs.

See article on original website

  1. ahmed desai
    August 17, 2011 at 11:19 am

    Dean,

    you are normally spot-on. But ths is incorrect. EU bond markets were rallying on expectation and actuality of ECB bond-buying- even while stocks were still plummetting.

    EU bond yields are back down to where they were a month ago, stocks are still registering big losses. The reason for the stock market turmoil is not the downgrade, as Treasuries yields are also lower.

    What normally pushes stocks down and bonds up? Slower growth. The stock markets began to plunge after the Congressional debt deal was announced, because it included its own US version of austerity. And even the dogs in the streets of Brussels know now, lower govt spending now leads to lower growth for years to come.

    It’s not the downgrade (yields are lower) or EU bonds (ditto), it’s ‘austerity’..

  2. Lucy Honeychurch
    August 17, 2011 at 1:21 pm

    Agree with Desai on the cause of equity downturn. This makes Baker’s case even more strongly. Austerity = slow growth = no revenue for market-traded companies. Market downturn/volatility was/is an equity-driven event.

  3. August 17, 2011 at 4:39 pm

    “People who understand economics know that Social Security and Medicare have nothing to do with the country’s economic problems.”

    Please explain how unfunded liabilities are not a long-term economic problem.

    • August 20, 2011 at 5:06 am

      Social Security is fully funded for decades. Liabilities we ought to worry about are the mark-to-make-believe assets on the balance sheets of too-big-to fail banks. Oh, and the climate change tsunami that is looming. Social Security has, what, nearly 80 years of never missing a check. Health care is half-baked only by the need to cut corporations in on what is a public good…. Ah, if you were going to be persuaded by facts, you would have been convinced already.

  4. August 17, 2011 at 5:20 pm

    I think the S&P downgrade had nothing to do with the so-called “creditworthiness” of the US and everything to do with financial market manipulation. Those “in the know” about the upcoming downgrade announcement would have been able to make a fortune on the predictable market swings that followed.
    Another case in point: 9/11.

  5. Podargus
    August 17, 2011 at 6:16 pm

    Fred Foldvary,please explain how Medicare and Social Security are unfunded.Time to wake up Fred,the gold standard disappeared years ago,thankfully.A sovereign nation with a fiat currency,as is the US,can fund anything it pleases in its own currency.

    BTW,Bill Mitchell thinks that the ratings agencies shouild be banned.I agree.

  6. cacciato
    August 17, 2011 at 6:38 pm

    there should at least be some mechanism to force ratings agencies to stop evaluating nations by the standards used for corporations.

  7. August 17, 2011 at 8:35 pm

    Unfunded liabilities consist of programs for which the present value of future real planned obligation payments exceeds the present value of real tax revenues at planned rates. E.g. the promised real payments for medicare are greater than the expected future revenue from the Medicare tax at the current tax rates (no tax increase has been enacted)..

    Of course the US government can create money, either directly with US Treasury Notes as with the Civil War greenbacks, or via the Fed, but that will not solve the real Medicare liabilities, because hospitals and doctors will need to be compensated for their real costs. Money creation will be offset by higher nominal prices. “Unfunded liabilities” means at the real levels of obligations. The Fed could buy up all the future federal deficits, but that would not fully pay for Medicare unless the real level of obligations falls.

    It might be a good idea for the government to print US notes and give everyone $10,000 in cash, but that would be to jump-start an economic recovery and reduce debt rather than to pay for the unfunded liabilities.

    • Wasabi
      August 18, 2011 at 3:05 am

      Fred, you should be calling for the expansion of Medicare, not cuts. Every cut to Medicare will mean less public control over the oligopolistic inflation rates in the US medical industry. The most effective way to get spiraling and unjustified inflation in the medical industry under control is by expanding Medicare. We should begin by lowering the entrance age for Medicare to 55 and aim eventually for a single payer system for all. This kind of Medicare for All system is used in almost every economically advanced country, where medical costs in relation to GDP average 55-60% of what they are in the US. Government is part of the solution, not the problem.

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