Home > financial crisis > Santa Claus and the S&P Market Crash

Santa Claus and the S&P Market Crash

from Dean Baker

Most adults know that there is no Santa Claus. They should also know that there was no stock market crash associated with the Standard and Poor’s downgrade of U.S. government debt. However, because powerful interests want to spread misinformation about the downgrade, people are likely to be much better informed about Santa Claus.

Before addressing the specifics of the S&P downgrade and its impact on the market it is important to discuss some background.  S&P gave investment grade ratings to hundreds of billions of dollars of subprime mortgage-backed securities – the asset at the center of the 2008 financial crisis. It also gave top investment grade ratings to both Lehman and AIG until the days of their bankruptcy, or bailout in the case of AIG. It also gave Enron a top investment grade rating until just before its collapse. Anyone relying on S&P’s assessments of creditworthiness would have lost a lot of money in recent years.

The specifics of the U.S. downgrade are consistent with S&P’s past performance. The Treasury Department uncovered a $2 trillion error in S&P’s calculations, but they still downgraded the debt anyhow.  It is also worth asking why S&P decided to downgrade when we were cutting our deficits rather than when we were raising them by extending the Bush tax cuts last December. If the lord works in mysterious ways, then the ways of S&P are heavenly indeed.

It would also be worth asking what S&P was saying with this downgrade. U.S. government debt is payable in dollars. The U.S. government must pay a certain amount of interest every year and then pay the principal when debt comes due, all in dollars. The U.S. government prints dollars. This means that if we ever reach a point where it is not possible to tax enough to pay our debt or to borrow enough, the U.S. government could always just print the dollars needed to repay its debt.

There are reasons this would not be desirable, most obviously the risk of inflation, but does S&P really think that we will forget how to print dollars? S&P could say that inflation is a form of default, except that they never said that in the past. We were not downgraded in the 70s even when inflation got into the double-digits. Furthermore, if S&P now expects the dollar to be eroded by inflation, and this is one of its criteria for default, it would have to downgrade all dollar-denominated debt everywhere in the world.

But S&P just downgraded U.S. government debt; therefore we can assume that it was not applying this inflation criterion for its downgrade. That is probably a good thing, since S&P is not in the business of making inflation predictions.

Of course even if the basis for the downgrade was bogus it still could have had a serious impact on the stock market. However a little common sense shows this is not true.

The S&P downgrade was most immediately a statement that U.S. government debt is more risky than had previously been believed. If anyone takes S&P seriously then it would mean that they attach a higher risk premium to holding U.S. government debt. This is the exact opposite of how the financial markets reacted. Bond prices soared as the yields on U.S. Treasury bonds fell to near record lows. It was as though the markets with one loud yell screamed out “we spit on your downgrade S&P!”

So why did the stock market plunge? Most policy people in Washington don’t know about it, but there is a currency across the Atlantic called the “euro.” The euro was on the edge of collapse because the debt crisis that was affecting some of the smaller governments was spreading to the euro zone giants: Spain and Italy.

It will be very expensive to support the debt of these countries. On the other hand, if they are allowed to default it would be a massive blow to the European banking system. This would likely set off the same sort of chain reaction and freezing up of the financial system that we saw after Lehman collapsed in September of 2008. It is not surprising that the very realistic fear of another worldwide financial collapse would send the stock market tumbling.

Tracing the reasons for the stock market plunge is not an idle exercise. There are many politicians and people in the media who are anxious to push the downgrade market crash story to advance their agenda. The moral of their story is that we got a huge market plunge because we did not reduce our deficits enough and then S&P had to downgrade the government. If we don’t straighten up and take our medicine, then S&P or one of the other credit agencies may do it again, and then we will get an even bigger market hit.

This then leads to the conclusion that we have to cut Social Security, Medicare and Medicaid, the huge social welfare programs that most of the working population either depends on now or expects to in their retirement. These are hugely popular programs among people of all ideologies, including Tea Party Republicans. Few politicians want to be associated with major cuts, but if the markets will crash otherwise there really is no choice.

As a practical matter, the stock market actually has little impact on the economy. Firms rarely rely on stock issues to directly raise capital for investment. More typically shares are issued to allow the original investors to cash out.

The main impact of the stock market on the economy is through its effect on consumption. Economists generally estimate that an additional dollar in stock wealth will lead to 3-4 cents in additional consumption.  This means that the $2 trillion lost at the low of the market would eventually imply a drop of $60-$80 billion in annual consumption (0.4-0.5 percent of GDP) if the market stayed at its bottom. That’s not trivial, but it’s hardly a disaster even in an economy as weak as ours.

The real story of the stock plunge is that it matters hugely to that small segment of the population that has substantial sums invested in the market. While less than one quarter of the population owns more than $25,000 in stock (including indirect investments though mutual funds and 401(k)s), virtually all the people involved in national economic debates fall into this category. This includes economists, reporters with major news outlets and senior congressional staffers and their bosses. The stock market may not matter much to the economy, but it matters hugely to the people who make economic policy.

This is why the story of the S&P stock crash is so important. Those pushing this line know that if they can get it accepted, cutting Social Security, Medicare and Medicaid is a done deal. Hey, no one wants to cut these programs, but it would be an economic calamity if “we” didn’t step up to the plate and take the medicine.  There is nothing more dangerous than a rampage of frightened policy wonks.

This means that we have to tell our stock-market-addicted policy makers that it wasn’t the downgrade that sank their retirement funds. If they are concerned about their 401(k)s they should demand stronger measures from the European Central Bank to support the euro. And, they should leave everyone’s Social Security, Medicare and Medicaid alone.

See edited version on original website

  1. September 2, 2011 at 2:45 pm

    If government chiefs leave Medicare alone, it will balloon to the extent that it will be financially impossible to preserve. We can’t ignore the mathematics of greater lifespans and the baby boom bulge. Indeed, coming gene-based medical technologies will increase lifespans even more, while adding to the growing expenses of medical care.

    • September 2, 2011 at 5:11 pm

      Come on Fred! What we need is a growth industry that is not weapons related for a change.
      Why is it OK to issue money for systems that kill people and not do the same for systems that cure people?

      • charlie
        September 2, 2011 at 6:39 pm

        @helge re Fred: Thank you for your comment Helge.

      • September 3, 2011 at 1:05 pm

        “Why is it OK to issue money for systems that kill people and not do the same for systems that cure people?” This is a different topic. I’m not a fan of these wars. The issue is not whether to cure people, but how to pay for it.

    • Wasabi
      September 3, 2011 at 6:54 am

      Fred, this is the precise reverse of what would actually happen. Expanding Medicare into Medicare for All (a form of single payer) is probably the *only* we will ever put downward pressure on the dangerous spiraling inflation in the oligopolistic and underregulated US medical industry, which is the reason Medicare costs are rising. Single payer is used in almost every economically advanced nation, and it has shown its cost-cutting power in all those countries, where health care comparable to that in the US is universally provided at 50-60% of health care costs in the US.

  2. September 3, 2011 at 1:02 pm

    It’s post hoc ergo propter hoc. US medical services are costly because of the link of medical insurance to employment, because of excessive malpractice lawsuit costs, because of a lack of an unhampered nation-wide market, and because of greater use of expensive technology. Also, maybe other countries are able to control fraud, but the US medicare and medicaid systems are plagued with massive fraud, as has been widely reported. Send a bill to Medicare, and they pay it automatically. Some of the cost of medical care to old folks is the costly treatment of final days of life. Do other countries spend so much for that?

  3. September 3, 2011 at 7:14 pm

    “Some of the cost of medical care to old folks is the costly treatment of final days of life. Do other countries spend so much for that?”

    Yes, in the UK. My father died aged 94 last Sunday, two years after my mother. They both received extensive treatment from the British National Health Service in their last decade of life. My father in fact had a quadruple by-pass when he was 92. It is, of course, not perfect – it is run by human beings – but every single one of us receives free comprehensive health care funded by general taxation for a fraction of the cost of the US system.

    • Alice
      September 4, 2011 at 2:31 pm

      Fred asks ““Some of the cost of medical care to old folks is the costly treatment of final days of life. Do other countries spend so much for that?”

      Strange – but I always thought the mark of a civilised society was the ability to care for its elderly or infirm.

      Amazing how the Scandinavians seem to be the last countries on earth not to have been infected with the “why bother worrying about anyone else but me” philosophies of the United States. They dont seem to think like that.

      Being of anglo saxon descent I cant say I agree with the implication that elderly US citizens who need treatment are costing the US government too much money.
      Its constant wars over many decades that have cost the US government too much money.
      Its also dereliction of duty to regulate the financial markets that has now cost many many millions of people around the globe a lot more money post slump. Yet still some maintain the faith of a small government, low taxes and obsessive deregulation. It seems the US is on track to anarchy if something doesnt change there.

  4. September 4, 2011 at 2:42 pm

    A free market does not necessarily imply small government, low taxes, or complete deregulation. A big enforcement of property rights, high taxes on pollution, the elimination of subsidies, and strong regulations to prevent fraud, are all consistent with economic freedom. Those who blame a non-existent free market for our economic woes seem to think that taxation, subsidization, and arbitrary restrictions do not exist or have no impact. Blaming the market for economic depression is like blaming unicorns for causing global warming. The USA has never had a free market. Regarding old folks, in a true free market, wages would be high enough so that one could buy insurance that would cover the high costs of final treatments such as keeping alive a body in a coma for a couple of decades.

    • Alice
      September 4, 2011 at 2:51 pm

      Fred – you say ” wages would be high enough so that one could buy insurance that would cover the high costs of final treatments such as keeping alive a body in a coma for a couple of decades.”
      a) wages are not high enough for that and b) that event is so rare as to be of no concern
      c) a totally free market would waste no time at all in eliminating wages completely.

      • September 4, 2011 at 4:58 pm

        Of course wages are not high today, because half of wages are taken by taxation, and wages are also taken when people pay taxes on goods. In a pure free market, neither produced goods nor wages would be taxed. If a free market eliminates wages, it eliminates labor, the wage level would be sufficient to attract and keep labor. Moreover, in a pure market, one can easily become self-employed, and easy self-employment plus full employment prevents the exploitation of labor.

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