Professor Neal Stoughton

Bad economic news over the past week has led some analysts to worry that the United States and hence the world is on the brink of a new economic downturn.

However the downgrade will have little practical impact as the US remained the world’s biggest economy and Europe provides no alternative to US bonds as a safe haven.

The downgrade of the US credit ratings on Friday by S&P is mostly cosmetic.  US bonds were already on ‘credit watch’ status, which has now actually been removed, although that has received little attention. The prospect of a real default by the US on its debt is remote.

There is still some room for manoeuvre, by engaging in yet more Quantitative Easing – or printing more money to ease an ongoing credit crunch. Unlike the European Union, or indeed any other enterprise in the world, the US Federal Reserve still has the unique ability to print more US dollars if it – and the US Treasury – deems that this is in the US economic interest.

The G7 group of major industrial powers has pledged to take whatever action is needed to stabilise the market, including a third version of Quantitative easing, or QE3.

It is far easier to simply inflate the money supply which results in a ‘soft default’ whereupon US dollars are devalued.  Given that yields on long term treasuries are still extremely low by historical standards – despite the ratings downgrade – the impact of having to borrow at slightly higher interest rates is very small.

Consider the comparison with Italy which is now having to borrow at around 6% yields which causes much more pain on its fiscal budgets. Therefore the upshot of this S&P ratings downgrade is not that significant in the scheme of things, especially when compared with the real crisis going on in Europe, which has comparatively greater issues.

Professor Neal Stoughton is the inaugural Macquarie Group Chair in Financial Services at the Australian School of Business.