For our cities and towns, the world is changing. The stable financial system that has been the support structure of America's suburban expansion is teetering. Our places have been built and reshaped on a premise of future growth. We cling to these projections, and continue to bet our future on them, more because we can't ponder the alternative; a country without growth. Will this be the week that ratings agencies officially acknowledge what has been true for some time now?
We want to say thank you all of our supporters that participated in our first ever Strong Towns insider conference call last week. We gave the select group that has supported us financially a preview of what we're working on and got their thoughts and feedback. A very productive time. If you'd like to join us, support Strong Towns and take part in such events in the future, you can make a tax-deductible donation on our website. Strong Towns is a 501(c)3 non-profit organization.
There are two narratives the country is being given today to explain our current economic condition. Both narratives rest on the notion that what we are going through is simply one phase of an economic cycle. If you are either hyper-partisan or bristle at broad generalizations, go ahead and skip the next two paragraphs. We are neither here at Strong Towns, so I will proceed.
The first narrative rests on the idea that government is the problem. Period. Government taxes the productive parts of the economy and gives that wealth to the unproductive parts. There is excessive regulation. Government spending (except for military spending) distorts the natural order of things. We should be looking to grow our way out of the current downturn by reducing taxes, reducing government spending, cutting regulation and basically getting out of the way to let the free market work (except when it comes to pork spending in our own districts).
The second narrative rests on the idea that government is part of the solution. We have a lack of demand in the economy brought about by greedy Wall Street banks blowing up the housing sector. Stimulus spending saved us from going into the financial abyss. When there is a lack of demand in the economy, government needs to step in and do more. (And when times are good, government needs to step in and help those left behind). We should be growing our way out of this financial crisis by taxing those most well off and using that money to make up for the lack of demand.
Let me offer a third narrative. Ask yourself if you think this is closer to explaining reality as you experience it.
We're not in a cyclical recession or some type of downturn that will eventually fix itself. There are no set of policies that we can adopt that will put us back to "business as usual" in America. After decades of pursuing growth for the sake of growth (the common denominator of both current narratives), we've found that we've reached a point where our version of growth can no longer be sustained. Buoyed for two generations artificially by economic stimulants concocted by the left and the right, as well as a one-time fossil fuel panacea, the balloon we've floated as the "American Dream" is now coming back to earth. The only real question now is how we land.
Last week, the Department of Commerce revised downward a whole bunch of economic statistics, including GDP growth for the first quarter of this year, which is now believed to have grown at an annual rate of 0.4% instead of the less-depressing rate of 1.9%. Sound like a radical shift? If so, ponder this: Commerce also went all the way back to 2007 and revised that fourth quarter from -4.1% to -5.1%. Yes, you read that correctly. Three and a half years later and they still don't know exactly what happened.
This is the backdrop for the first of two points that need to be made about a potential downgrade of our credit rating, and it is really important to understand, especially in the context of the current debate over the debt ceiling. Regardless of whose numbers you use -- House, Senate, White House, Democrat, Republican, Tea Party, Wall Street, Commerce Department, etc... -- the projection for growth over the next ten years is an annual average of 4%. This seems reasonable when projecting from an excel spreadsheet of post WW II growth, which has been upward at more than 4% annualized, but if you don't subscribe to the two prevailing growth narratives, it seems wildly optimistic.
And if the difference between 4% and say....3% doesn't sound like much, consider this: the debt limit deal worked out yesterday after so much acrimony would cut spending by $2.2 trillion over the next ten years. The difference between a 4% and a 3% growth rate over the next ten years: $2 trillion in lost tax revenue. The difference between a 4% and a 1% growth rate is $5.6 trillion. And that is still with growth! What if Detroit, Vegas and Phoenix are not economic anomalies but canaries in the coal mine, just the weakest links in a system of growth that is inherently weak? What if we don't have growth but contraction?
The first thing to understand about this rating is that it has little to nothing to do with the debt crisis or our near-term financial position and, as such, is essentially bogus. Economists and statisticians can't accurately project the growth rate over the next three months, or even account for the growth rate from three and a half years ago, yet a difference of just one percent in our projection for the next decade will completely offset the most difficult cuts to our budget that we've made in recent times. And despite this volatility, we have a AAA rating, meaning there is the absence of all risk? Nonsense.
Put another way: there is nobody with serious money looking at the ratings agencies for advice on the credit worthiness of the United States government. The rating is an accounting check box. It does not reflect the actual riskiness of U.S. debt or our ability to repay, particularly if stressed.
That does not mean the rating doesn't matter. It matters a lot. Roughly 60% of the world's currency reserves are in U.S. dollars. Why? Because they are liquid -- there is always a market for them because the U.S. is the world's reserve currency -- and they are rated AAA, so they are accepted everywhere. For example, banks in Brazil are required to hold American dollars as part of their reserves. If we lose the AAA rating, these banks may have to dump their dollars and replace them with other forms of backing.
The AAA rating also creates demand for dollars from all kinds of securities and financial funds worldwide. Say you run a managed fund where the portfolio is required to maintain a AA rating. You may have a bunch of lower-rated, riskier and higher-yielding securities, but you then blend your holdings with AAA dollar-backed debt until your total holdings average out to AA. Drop the dollar rating just a notch, and you are forced to do a massive rebalancing that will include dumping dollars into the market.
So here's the second thing to know about the credit rating: Unlike Greece, Portugal, Ireland or any other country in the world, as the United States is minting the world's reserve currency, a downgrade of our debt could be devastating. If the U.S. dollar drops and people start to unload dollars -- even slightly as part of a rebalancing -- it could have dramatic impacts just because there are so many dollars out there. When dollar-backed debt is sold into the market, there needs to be a buyer. If there are not enough buyers, only one thing can happen: interest rates will go up. That is how you get people to buy your debt; you give them a higher interest rate.
Interest rates have been at historic lows, but what if they returned to just the average rate we've experienced over the past thirty years? As we pointed out last April, that would add $7 trillion in interest payments over the next decade. What if the dumping of dollars brought the interest rate up over the average to the high from the past three decades? Well, then you'd be talking $20 trillion in additional interest. It makes our hard-fought cut of $2.2 trillion over the next decade look silly by comparison.
Our credit rating should have been downgraded a long time ago. When you get beyond the economist's view of debt to GDP ratio and look at the sheer volume of debt, the short-term way the debt is financed, the additional promises we have made and the obligations we have, the impossibility of growing our way out of these problems, the lack of resiliency in our economy as a whole (we import more than we manufacture in total, for example), our extreme fossil fuel dependence, and the obvious fact that we really have no plan or even a remote intention of repaying our debt but project to forever borrow more and more, how can we possibly have a AAA rating?
To me, the debt ceiling debate is silly. The constraint we have is not whether or not we are willing to borrow more money. We've put ourselves in a position where we essentially have to, as nearly every politician has said. The constraint we have is how much longer the world will be willing to lend to us. They do so now because the balloon is still in the air, everything is essentially frozen, and there is no better place to go. But when the trickle starts -- as it could with a downgrade -- there are so many dollars out there that may come pouring back that the result is anything but predictable.
This is not the stuff of a resilient economy. And not the stuff of a AAA rating. The only thing that has kept a downgrade from happening thus far is the natural human instinct to not want to be the first to shout that the emperor has no clothes.
We need to start a conversation about contraction and how to transition to a living arrangement we can actually financially sustain. It is going to look much different than the way we currently live. And, unfortunately, we should have started the transition a long time ago.
- Bureau of Economic Analysis Press Release (July 29, 2011)
- Our unfaithful partner (April 11, 2011)
- The Black Swan by Nassim Nicholas Taleb
- Crisis Economics by Nouriel Roubini
Strong Towns is a 501(c)3 non-profit organization. Please consider making a tax-deductible donation to support this blog and our other efforts to build a stronger, more resilient America.