The debt downgrade and inflation prospects

US government debt is the most widely traded financial instrument in the world.  As such, there are plenty of financial analysts that understand its risks better than the analysts at Standard & Poor's.  Therefore, if US debt prices fall today, they probably would have fallen even without the downgrade, based on analyses done continually by thousands of professionals around the globe.

Yes, there might be a temporary panic stoked by Big Media alarmists hoping to garner TV news ratings or website hits.  However, if that's the only reason for a price drop, professional traders will view the panic as a buying opportunity in an oversold market.

Other alarmists claim that mutual fund managers are handcuffed by their own prospectuses and must sell the downgraded US debt.  But most funds hold relatively small portions of such debt and there are enough contractual loopholes that the fund managers easily can slip out of those 'cuffs.  And ironically, if panicked investors simply liquidate their mutual fund holdings, it might drive government debt prices up, because the proceeds typically get "parked" in US debt products.

S&P's August 5 Research Update implies that its own analysts were the last kids on the block to realize that US debt as a percentage of GDP is in dangerous territory.  S&P also seems to have grasped only recently the long-term economic threat posed by tens of trillions in unfunded entitlement liabilities, due to the demographic "graying" of American taxpayers.  In the private sector, those liabilities must appear on a firm's balance sheet, so any analyst that took an accounting course should have been worried about them for a long time.

Furthermore, S&P alluded to the risk of near-term default posed by last month's unresolved debt ceiling debate.  That claim is false.  Only the president (via his Treasury Secretary) could have ordered such a default and had he done that, he probably would have been impeached. 

Still, most of the problems S&P cited pose only a long-term default threat, so its recent downgrade is unwarranted on that basis alone.  Inflation is a bigger threat to real returns, but there was little explicit mention of it in the Research Update.

In a perverse way, if S&P could convince consumers and investors that greater inflation is inevitable because the government has no choice but to monetize its debt, that actually could help the near-term US economy.  At the moment, three problems have stalled the economy: horrid fiscal policies, regulatory uncertainty, and low inflation expectations.  Because of Democrat intransigence, the first two only can be solved by regime change in January 2013.  But rising inflation expectations would reduce demand for "hot potato" dollars and boost spending and investment now.  That might keep the US out of a depression until the 2013 "economic spring" arrives.