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The S&P Downgrade and Stock
Market Volatility

August 31, 2011 by Somebody Else

Up until the end of July of this year, the stock market seemed to be doing pretty well. True, it still hadn't reached the record level set back in 2007 just before the onset of the recession, but it had nonetheless recovered considerably from the terrible low of early 2009. And although the overall economic outlook was far from rosy, there was some reason for cautious optimism. Employment levels had been slowly inching upwards over the last several months. Corporate earnings had also been improving somewhat. There seemed to be a sense that we had left behind us the worst days of the so-called Great Recession and had started moving in a new direction.

However, all was not well in Washington. The deadline for approving the federal budget was fast approaching, and the Republican Party had made up its mind to dig in its heels and oppose the customary raising of the debt ceiling.

In brief, the Republican argument went like this. Yes, we've raised the debt ceiling every time the matter has come to the floor since time immemorial. But this time, things are different. Due to the current economic crisis, we cannot afford to continue to allow our government to live beyond its means. The time has come to draw a line in the sand. The debt ceiling must be held where it is. If we can't make any inroads against our debt in the short term, we should at least insist that it not be increased beyond its current level.

At first glance, this might seem to be a perfectly reasonable argument. After all, regular working people like you and me have to live within our means, or else. We don't have the luxury of raising our debt ceiling every few years. In fact, we aren't even really given a debt ceiling at all. We either pay our debts on time, or we get tossed out on to the street and have all of our stuff repossessed. Why should Washington be any different from us?

With those kinds of arguments, the Republicans almost seemed to be coming across as defenders of the little people in this country, that is, those of us who don't get any breaks, who have had to weather the economic storm of the last several years, and who have gotten no special treatment or assistance.

Let Washington default on its debts, so the argument went, that way, maybe they'll learn some responsibility, kind of like that profligate cousin of yours who always borrowed everything from everyone and finally went bankrupt because they decided to tell him enough is enough, and put a stop to the loans. He had to start over from scratch, but it was a valuable lesson learned.

Sounds good, but it's a misleading and oversimplified comparison. We seem to forget some very basic and fundamental truths, which are the following. If our government defaults on its debts, we are the ones who will ultimately have to pay, and perhaps most importantly, the world is watching us. And let's not forget, our national economy and the international economy, closely connected since our origins as a nation, are more intimately linked with each passing year. International opinion matters, and has an immediate impact upon our financial markets. Simply stated, if we don't look like we have our act together, there are negative consequences for foreign investment.

The Republicans were of course aware of these factors, but they made a calculated decision. Realistically, they understood that their chances of holding the debt ceiling were slim to none. However, they figured that there were some political points to be gained by making a unified show of opposition to the customary increase. Weighing the pros and cons, they decided to go for it.

As it turned out, that game of political chicken went right down to the wire. Democrats, equally convinced that the ceiling had to be raised and resolving not be bullied into submission, held the line against the Republicans. With an administrative and economic Armageddon fast approaching, cooler heads finally prevailed and a last-minute compromise that pleased nobody was cobbled together. Washington breathed a sigh of relief, and for a brief moment at least, there was a sense that the crisis had passed.

But all was not well in New York, where Standard and Poor's, known by the acronym S&P, was mulling over the recent showdown in Washington. After meeting for several house behind paneled mahogany doors draped by crushed black velvet curtains, several distinguished-looking gentlemen in very expensive suits, sporting silk ties and custom-made Italian dress shoes, consulted amongst one another, and after carefully considering the financial reports supplied to them by their highly qualified and experienced subordinates, decided that the time had come for a momentous decision to be taken.

They concluded that they were not impressed with the immature and irresponsible debt ceiling game they had recently witnessed, and decreed that a bit of instructive punishment -- a fiscal spanking, if you will -- was in order. For the first time in its history, the United States was to be stripped of its coveted AAA rating, and would be demoted to the lowly classification of AA.

Then, their work finished, these S&P executives went home to their multi-million dollar mansions, and rested up from their stressful, earth-shattering tasks by soaking awhile in their gold-plated Jacuzzi tubs and smoking Havana cigars.

Well, you might have thought that an atomic bomb had been dropped on this country. The White House declared that it had been "amateur hour" at S&P. Republicans blamed the Democrats for the downgrade, but one suspects that the decision would have been the same even if the debt ceiling had been held as the Republicans had wished.

Even though S&P is a non-governmental organization, and even though all other major ratings agencies allowed the United States to keep its AAA status, still, there was no denying that real damage had been done. Because of the S&P decision, the United States can no longer borrow money at as low of an interest rate as it could as an AAA nation. That has already had a major impact upon our economy, and will continue to do so for years to come.

So, the initial reaction from Wall Street was pretty predictable. There was a massive selloff that originated in fear and was fed by fear. Stockholders were afraid that other stockholders were afraid, and that made them more afraid. Would the S&P decision wreck the economy? Nobody seemed to know, but that wasn't the point.

No, the point was simply that a lot of people might think that the S&P downgrade would create serious financial woes, and based on that supposition, it was time to move money out of stocks and into supposed safe havens, such as gold and US Treasury Bonds.

To aggravate the crisis even further, bad news was coming in from Europe, where countries like Greece and Ireland were facing serious debt crises. The European Union was confronting the dreaded prospect of having to bail out one or more of its member nations. Considering the possible long-term impact of Europe's problems, the stock market sunk further.

And if that weren't enough, recent economic indicators in the United States didn't turn out to be as robust as previously expected. Discouraging talk of a double-dip recession once again moved to the front of the news feed. The Dow Jones took yet another gut-wrenching dip.

However, as was soon to become apparent, there was not a unified consensus about what the recent negative news might mean. For that reason, the stock market entered into a period of extreme volatility without parallel in its history. The market lost 500 points in one day, then, gained as many the next. This went on for the better part of a week.

It seemed as though all of the extreme movement on Wall Street was based upon nothing more than perceptions of what the perceptions of other stockholders might be. Did everyone think that things were heading into the toilet? Sell, sell, sell! Did everyone think that stocks were undervalued and that it was a great buying opportunity? Buy, buy, buy!

So, a lot of stockholders were acting like sheep in a flock. Wherever the other sheep were running to, that's where they too would run, all of which underscores the simple fact that nobody really knew what the long-term prospects for the economy were.

All the volatility, latest economic figures, and S&P downgrade aside, the big question on the table is a very simple and basic one, which is this. Does the United States have what it takes to move forward and continue to progress as a nation with one of the world's strongest economies?

Warren Buffett seems to think so, since he just put five billion dollars into Bank of America, which had been looking like it was about to head off the side of a cliff.

Now more than ever, the words of Franklin Roosevelt ring true:

"We have nothing to fear, but fear itself."

So much for S&P's downgrade. They can get back to their weekend outings on their yachts. The rest of us will get back to moving the United States on to the next stage of its development.

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