IOU = UOMe

A sentence you never expected to read here: well done S&P for your timely action in placing the USA's AAA credit rating "under review". (Slate story by Annie Lowrey here). All past experience would have suggested that S & P (and its equally farsighted rivals at Moody's) would only have taken such an action the day after the US had actually defaulted on its debts and thrown the global financial system into meltdown. Instead it's almost gone too far in the opposite direction: its warning is not over an imminent fiscal problem, but over the longer-term consequences if American politicians can't get their act together in 2013. (They're assuming, almost certainly correctly, that nothing meaningful can get done before the 2012 Presidential elections).

A crisis of some sort could, of course, come sooner than S & P predicts. The debt ceiling needs to be raised in the next few weeks, or a government shutdown will be inevitable in May, and the US would become unable to repay its maturing debts some time in early July. There were few signs of willingness to compromise during the recent budget standoff, so this can't be ruled out, but even if some sort of deal gets made, S & P is surely right to assert that something needs to be done before too long to set the US on a more sustainable fiscal course. Mohamed El-Erian of PIMCO, a man who knows a bit about bonds, has called the S & P move "a timely warning".

The most fatuous comment so far on these events has come from one UK commentator (left nameless to protect the guilty) who suggests that a US ratings downgrade might not matter that much. After all, the "argument" goes, Japan lost its AAA rating a decade ago and currently borrows money at 1.25%. That's true, but it borrows at those rates from its own savings-obsessed people. Japan is not constantly rampaging around the world in a desperate hunt for new creditors, as the US is. Borrowing from abroad changes the whole complexion of the problem. Let's look at that in more detail.

There have always been plenty of economists who are prepared to argue that government borrowing is harmless because "we owe the money to ourselves". That's sometimes expressed in the "IOU = UOMe" identity, and if you recall your high school algebra, you can strike out the common factors on each side, which reduces the equation to the obviously true proposition, "I = Me".

So there's no problem, right? Well, that might have been the case at one time in Japan (or Italy, another country of savers), but even in those cases there are issues. For one thing, borrowing risks transferring wealth from the poor (who get taxed to pay the interest on the borrowings) to the rich (who get taxed, but also earn the interest on the bonds). For another, there's the intergenerational aspect: "I" am borrowing the money now, but the "Me" who's being counted on to pay it back may actually be Mini-Me i.e. my children and their children, who weren't consulted. You can make a case for this as long as "I" am borrowing to invest, but it's a lot harder to justify if "I" am just consuming the proceeds. And the case gets even tougher to make if there are just not enough Mini-me's in prospect to repay the debt, as a result of demographic trends. This is Japan's predicament now.

In the debt-happy USA, of course, the "IOU" equation stopped being relevant years ago. Americans owe money to everybody, including a lot of countries they'd really rather not be beholden to. It all works fine as long as the US dollar remains the preferred international reserve asset, because that means that foreign investors are willing to hold the dollar-denominated debt that the US spews out in order to finance its spending. However, there are signs that the appetite for USD assets may be approaching its limits. OPEC countries seem to be trying to move away from exclusively dollar-based pricing. Criticism of US profligacy and the tidal wave of dollars it creates is being heard even from notionally friendly countries like Australia and Brazil, who are afraid of another bout of asset price inflation.

There's no sign of a buyers' strike over US debt yet (although the US is certainly not able to borrow at 1.25% or anything like it), but the S & P rating action should serve as a warning that things could change, and if they do, the ramifications for the global financial system are terrifying. Whether this concentrates the minds of the White House and its array of opponents remains to be seen; it's just as likely to become another element in the endless high-decibel buck-passing and mudslinging that has supplanted fiscal debate in Washington.