The Standard & Poor Downgrade of Uncle Sam

By now, everyone knows that S&P downgraded the debt of the USA from their top rating, AAA, to their second-highest grade, AA+. Most of the commentary has been of the pin-the-blame-on-the-donkey variety. For all most people know, this is the collapse of the currency and the financial system and their biggest concern is that Obama not win the 2012 election. If this were truly the collapse, I submit for your consideration that we will all have bigger things to worry about!

So, I thought I would look at this from a different angle. My conclusion is simple. On the one hand, there is no question that the US dollar will collapse. This is not only inherent in any irredeemable paper money, but also the inevitable result of any government and financial system that runs perpetual and accelerating deficits. But this is not what S&P is considering! If it were, they would re-rate all dollar-denominated debt at their lowest level. They would then look at the dollar derivative currencies (e.g. eur, gbp, yen, etc.) and realize that a derivative cannot survive the destruction of the underlying currency. So they would do the same to the sovereign debt of the issuers and all debt denominated in those currencies. Then they would lay off their staff, awaiting the return of gold-denominated bonds.

Dollar collapse aside, consider that in 1913, when Wilson created the Federal Reserve, a dollar was worth roughly 1/20 ounce of gold. In 1933, Roosevelt devalued the dollar to 1/35 of an ounce. In the 1960’s, the US government was obliged to give up more and more of their gold hoard to “defend” this level, because by then the real value of the dollar had fallen well below 1/35 ounce. We can’t know how much it had fallen because the government interfered with the process of price discovery.

After Nixon officially defaulted on the gold obligations, the dollar’s collapse accelerated. By 1981, the dollar was worth 1/600 ounce (ignoring the spike into what turned out to be a mania). Today, the dollar is worth less than 1/1700 ounce of gold.

I am not aware of anyone who thinks that the government will get the dollar’s fall under control. Any Keyesian or Monetarist will even tell you that it’s good for the dollar to fall. And we Austrians are saying that not only is it bad, but it’s happening and it’s accelerating.

If the S&P rating was intended to account for the value of the currency that the debtor uses to repay its bonds, then how could S&P give the USA an investment-grade at any time under any circumstances? If the dollar is losing 5 to 15% of its value per year, this represents a significant default over the duration of a 10-year bond!

And, for that matter, the same dilemma would apply to corporate bonds, municipal bonds, etc. Obviously S&P does not look at the dollar, and its constant propensity to fall, as part of its rating process.

To summarize my points so far, the dollar has been steadily eroding for 100 years and this is a trend that those in charge defend as being good and necessary. And the dollar will collapse under the weight of unpayable debts. This is the fatal flaw of an irredeemable debt-based currency, and the end is in sight if not imminent (see my paper on gold backwardation).

In this light, the S&P downgrade is meaningless.

On the other hand, in the world of the irredeemable currency, what does it mean for a bond to be paid back? It means that the debt is transferred from one party to another party. If a corporate bond is repaid, the corporation redeems it using dollars (i.e. Federal Reserve Notes). Dollars are the liability of the Fed. The debt is simply transferred. First, the corporation owes you. Then the Fed owes you.

This is an insane system, but at least there is an arms-length transaction between unrelated parties. It is possible to discuss default, attempt to qualify (if not quantify) the risks of default, etc. Default or non-default: these are the only two possible outcomes for the bond at maturity. One of them will occur, and which one occurs is of utmost importance to the bond buyer. The goal of the ratings agency (assuming repeal of the 1970’s era law making them work for the bond issuer) is to assess the risks of a bond being paid or not.

However, Treasury bonds are payable in Federal Reserve Notes which are backed by … Treasury bonds. It’s circular, it’s a check-kiting scheme, and it’s a Ponzi scheme.

There is no risk that there won’t be Federal Reserve Notes to pay the bond holder. Both the bonds and the notes that are used to pay them off are inextricably tied! The point I am making here is that the very concept of “rating” such bonds is meaningless. There is no objective (or otherwise) standard of measure to use in rating them.

It would be like asking how much gold is an ounce of gold worth? How many dollars is a $100 bond worth? These are tautologies.

This is just one of the perverse “unintended” consequences of trying to use irredeemable paper currency. Government debt paper is debt paper. Money (gold) is money. The two are the same, like oil and water are the same.

The world needs to return to a proper, unadulterated gold standard including bonds redeemable in gold. And this must include repealing the laws that grant a cartel to the three ratings agencies (S&P, Moodys, and Fitch), so investors can hire any firm to help them with due diligence on the bonds they buy.