Monday, August 08, 2011

The Unpleasantness Continues

Amplify’d from
Lots of moving pieces tonight as financial centers around the world prepare for the impact of the S&P downgrade of US debt and the ongoing Eurozone debt crisis.  The list:
ECB Finally Ready to Come to the Table.  The ECB is signaling they are prepared to buy up massive quantities of Italian and Spanish debt, hoping to put a firewall around the European debt crisis.  Of course, this isn’t the first firewall European leaders have set, to no avail.  Perhaps this time will be different.  Paul Krugman argues, I think correctly, that at least for Italy the issue is seemingly a liquidity crisis, not an insolvency crisis. 
The G7 Communiqué.  The G7 finances ministers and central bankers met over the weekend and more or less confirmed their commitment to fiscal austerity:

We are committed to addressing the tensions stemming from the current challenges on our fiscal deficits, debt and growth, and welcome the decisive actions taken in the US and Europe. The US has adopted reforms that will deliver substantial deficit reduction over the medium term. In Europe, the Euro area Summit decided on July 21 a comprehensive package to tackle the situation in Greece and other countries facing financial tensions, notably through the flexibilisation of the EFSF. We are now focused on the quick and full implementation of the agreements achieved. We welcome the statement of France and Germany to that effect. We also welcome the statement of the Governing Council of the ECB.

The Federal Reserve.  As I argued last week, the usual guides to monetary policy, a combination of Fedspeak and data flow, are not conducive to a near-term policy shift.  An overriding factor, however, would be financial crisis, and the G7 statement seems to raise the current circumstances to crisis level.  This should give the Fed a green light to act.  I still think the best option is to come in before the market opens and announce they are buying $100 billion of Treasuries.  Just get ahead of this.  The problem is that so many Fed policymakers have come out seemingly dead set against any additional bond purchases that action just a day before the next FOMC meeting seems like a big leap. Still, a financial crisis is a good time for a big leap.
The S&P Downgrade.  Lot’s of speculation on the competence of S&P.  They obviously messed up on the math.  And let’s not forget the role they played during the financial crisis – aren’t any mortgage backed assets investment grade?  They are if you want to keep earning your fees.  But Ezra Klein and Felix Salmon argue that the circus of US politics warrants a debt downgrade.  After all, a small but apparently vocal contingent thinks the debt-ceiling is no big deal, and is actually willing to press the button to prove their point. 
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Finally, we don’t completely know the knock-off effects on the rest of the financial system.  From the Wall Street Journal:
The downgrade late Friday had implications for a range of entities with links to the U.S. government or holdings of its debt, running the gamut from mortgage giants Fannie Mae and Freddie Mac to large insurers to securities clearinghouses—not to mention rates on consumer loans such as mortgages that are linked to Treasury yields.
The risk for all these borrowers is that the downgrade to double-A-plus, even though by just one of the three major rating firms, could result in slightly higher interest rates. Those costs might be small for each borrower, but in total could essentially mean a tightening of credit in the country at a time when a weak economy can ill afford higher rates.
Good luck today.