Sorry Mr Buffett, it's you who has got it wrong, not S&P

Does a country whose debt is as big as its GDP deserve a Quadruple A rating? This is what Warren Buffett, doyen of investors, wants us to believe.

R Jagannathan August 08, 2011 13:02:04 IST

Perhaps, this is a good time for Warren Buffett to retire. The man who made millions from the mispricing of stocks and securities has a vested interest in talking up the market. But this time it won't work.

Among other things, he said last week that the US deserved a Quadruple A credit rating when the S&P decided to bring it down to Double A+. He also believes the US will avert a double-dip recession.

Well, Mr Buffett, you are already half-wrong. A slow-growing nation with a 100 percent debt-to-GDP ratio cannot be Quadruple A by any stretch of economic logic. It makes India's 70-72 percent debt-GDP ratio look like the epitome of prudence. As for the other half of your prediction - that the US will avoid a double-dip recession - the jury is out on that one, but the recession wasn't the reason for the S&P downgrade last Friday anyway.

Sorry Mr Buffett its you who has got it wrong not SP

Mr Buffett, unless the US gets its act together, it will not just get the Quadruple A rating, but slip further down in ratings. AFP

There are two reasons, or maybe three, why the US is in a mess. One is that it is overleveraged - in deep debt - both at the level of government and the common people. Two, the law that the US can indefinitely live beyond its means has a flaw. It was built on the assumption that dollar debts can be paid off by printing more of the green stuff forever.

The world is now wary of this American Ponzi scheme. Between 2001 and now, the world's holdings of dollars as part of official foreign exchange reserves had dropped 12 percent.

Three, during the economic tailspin of the last three years, the US has become more divided as a nation than ever before. Parties on the Right-wing fringe - from the Tea Party crowd to the neocons and other weirdos - are now making it impossible to develop a political consensus in the middle - as the US debt deal showed. Unless this changes, the US is unlikely to be able to tackle its economic woes effectively.

Let's examine the issues more closely, Mr Buffett. US debt is only going to get worse in the short-term. While the public debt figure is $14.2 trillion (98 percent of GDP), it will cross 100 percent if debt rises and/or GDP growth falls.

When citizens are up to their eyeballs in debt - largely due to unbearable home loan burdens - they are not going to be consuming more. When citizens hold back on consumption, the economy can only slow down and fall no matter how many sackfuls of dollars you print.

While there is no urgency for Uncle Sam to immediately deleverage - it would be suicidal when the economy is in a tailspin - the US public has to do that no matter what (reduce debt, that is).

The correct answer to the problem is thus not merely monetary easing, but debt forgiveness. Once the US uses its deficit financing to write off debts, people will borrow again, and stop behaving as though the roof is going to cave in. This is what is going to restore consumer confidence, and bring the US back to the growth path- not deficit reduction. (That can come later) You can't ultimately reduce a fiscal deficit without growth. Only growth can bring in taxes and deficit reduction.

As Paul Krugman, professor of economics at Princeton University, noted even before the debt deal was announced:

"The (debt) deal itself a disaster, and not just for President Obama and his party. It will damage an already depressed economy; it will probably make America's long-run deficit problem worse, not better... it will take America a long way down the road to banana-republic status."

In fact, what is true for the US is equally true for Europe. Unless Germany agrees to write off a part of the debt owed by its PIIGS (short for Portugal, Ireland, Italy, Greece and Spain), there is not a snowball's chance in hell of ever getting Greece or anybody else to the growth path again. The euro and the monetary union will be dead by then.

As Kenneth Rogoff, professor of economics and public policy at Harvard, points out in an article for Project Syndicate:

"The real problem is that the global economy is badly overleveraged, and there is no quick escape without a scheme to transfer wealth from creditors to debtors, either through defaults, financial repression, or inflation."

Rogoff is clear that what we are seeing in the US is not - yet - a recession, but a huge credit contraction which is keeping the US economy from bouncing back.

He says: "A more accurate, if less reassuring, term for the ongoing crisis is the 'Second Great Contraction.' Carmen Reinhart and I proposed this moniker in our 2009 book This Time is Different, based on our diagnosis of the crisis as a typical deep financial crisis, not a typical deep recession. The first "Great Contraction" of course, was the Great Depression...".

If Rogoff is right, Buffett is wrong. The US cannot have a Quadruple A rating when both the country and its citizens are in deep debt. It deserves its derating till it fixes this problem.

Buffett is right to believe in the future of the US economy since it is obviously the most dynamic one in the world, but deleveraging is a must.

Meanwhile, the world is certainly beginning to short-sell the US economy and the dollar. Between 2001 and now, the world's holdings of the US dollar fell by 12 percent - from 73 percent of official reserves to 61 percent.

Now, with the US downgrade, what's the bet that this pace will accelerate, to say, 20 percent over the next five or 10 years?

The financial markets do not work slowly and steadily. When something goes wrong, corrections accelerate and bring on the very crisis one was trying to avoid.

If the world starts believing it should diversify away from the dollar - as it has been doing for the past 10 years - the chances are that it will do so even faster in the next 10 years.

Mr Buffett, unless the US gets its act together, it will not just get the Quadruple A rating, but slip further down in ratings.

Watch video: ' I don't get it . It doesn't make sense what S&P did'

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