This blog post originally appeared on RealMoney Silver on Aug. 8 at 8:59 a.m. EDT.
World leaders face a choice of truly historic proportions. They can follow one of two paths. The first path would require them to finally admit their prior policy errors and embark upon comprehensive reform of all of the fiscal policies that affect the economy -- energy, education, tax, business regulation, technology and science policy and industrial policy -- in order to give their economies a chance to grow through productive investments. (By the way, these investments and policies would also have the side benefit of improving the quality of human life.) This path would also require central bank discipline on the long-lost Paul Volcker model. Or they can stay on their current path and continue to monetize their debts in the hope that future generations will be able to repay them with deflated currencies and the markets won't abandon them. The choice is clear. The question is whether leaders will have the courage to make the right one, and their citizens the fortitude to stand behind them.There is nothing revelatory in the Standard & Poor's downgrade, which puts us in a tie with Belgium, as it is largely symbolic. The downgrade reflects known facts. There is plenty to be critical of, however, in the manner and composition of S&P's decision, and I suspect that will be the subject of a lot of commentary in the week ahead. The optimistic view is that we will see renewed leadership under the current period of crisis. Rather than being seen as a continuing political football of partisanship, the S&P downgrade (when coupled with the stock market swoon) could become a catalyst for change -- a clarion and wake-up call for both parties to address our country's fiscal imbalances. (This subject was a prime topic on The Edge last week.) Indeed, investors could grow more constructive that a November select committee meeting of Republicans and Democrats will now be galvanized into finding another $1.5 trillion in new deficit reductions, providing the opportunity for a "grand bargain" by finally addressing tax reform, Medicare, Medicade and Social Security (importantly in an up-or-down vote.) There are other reasons why there may not be a sustained risk-off reaction:-- Michael Lewitt, El Mundo (Aug. 8, 2011)
- S&P's downgrade move was previously telegraphed. Most market participants expected the move in light of earlier warnings by S&P and the disappointingly modest size of the deficit reduction that was the outgrowth of last Monday's budget compromise.
- Other ratings agencies are staying put. Moody's and Fitch have maintained their AAA rating for the U.S.
- Risk weightings are unchanged. The move will not affect the risk-weighting of Treasury assets held by banks.
- Banks have ample liquidity. Our financial institutions can readily absorb any short-term funding disruptions.
- Sentiment is already poor. Investor expectations are already low.
- Investors are on the defensive. Hedge funds are sitting on their hands, and, as I have observed, so are individual investors -- and both classes of market participants have de-risked, so margin calls are not really coming into play.
- A precedent had been set. History shows (e.g., Japan) that an S&P downgrade has a negligible impact on the economy and markets.
- S&P has lost some of its influence and much of its credibility. A $2 trillion mathematical miscue , the political spin associated with the downgrade and the change in the assumption regarding the Bush-era tax cuts further strain and undermine the ratings agency's move.
- S&P's move was discounted. Just as the debt ceiling compromise last Monday was obviously already priced into the US stock market (as the market failed to rally) - so is it possible that much of the US debt downgrade has already been incorporated in share prices (and might not decline much further).