The Guest Blog

Henes: Top 5 Questions About the Downgrade, the Economy, and the Markets

Jonathan S. Henes, P.C.|Kirkland HKSCKPVIamp; Ellis LLP

The U.S. debt ceiling "deal" wasn't sufficient to stop Standard and Poors from downgrading the U.S.

Currently, we are faced with a stalled economy, a debt crisis in the U.S., a European sovereign debt crisis, political dysfunction in the U.S. and Europe and "The Downgrade."

This is all coming on the heels of the worst economic crisis in the U.S. since the Great Depression.

So, what does it mean? What will it mean for the economy, the markets, and our future?

In the U.S., is it the fall of the Roman Empire or will our anemic growth pick up steam and help us out of the economic doldrums? As we head into the the second week of August 2011, and vacations are about to begin, here are five questions to consider.

No. 1. Does the Downgrade Matter? Yes it does. A lot of very smart people say it doesn't. They point to France, which is triple-A (although it shouldn't be), and ask, "Is France really a better credit risk than the U.S.?" I don't think this is the right question. The right question is, "How did we let this happen?" We are the United States of America. We are supposed to have the strongest economy in the world. We are not supposed to find ourselves in a position where people are unsure as to whether we will always be in a position to pay our debts when they become due. Also, if the downgrade doesn't matter, why is the Obama administration reacting so harshly to it? If it was really a mistake or a poor decision by Standard and Poor's, wouldn't we all realize that? Of course we would. What the downgrade really tells us is that we are in a fiscal and political crisis, and we need serious answers to serious problems before it is too late.

No. 2. Does China matter? Of course it does. While China has not commented officially on "The Downgrade," China's official news agency, Xinhau, said that the U.S. needs to “cure its addiction to debts” and “live within its means.”China, the largest holder of our debt, cares deeply about the U.S. debt crisis and "The Downgrade," as it needs to protect the value of its holdings. In other words, China is laser-focused on any events that could lower the value of those holdings. Guan Jianzhong, chairman of Dagong Global Credit Rating, said that the U.S. dollar may be discarded as the the currency of the world. These comments are shots across the bow of the U.S. and our political leaders need to take them seriously. We need to focus on how to keep the dollar strong, get our debt problem under control, and position the country to grow over the long term.

No. 3. Will the Markets Fall?

The Dow Jones Industrial Average has already given up its gains for the year. As I write this—it's 8:01 a.m. Monday—the Dow futures are down 1.86 percent, the Asian markets ended down more than 2 percent and Europe is down almost two percent(even with the European Central Bank announcing it will start buying sovereign debt in the open market).

The U.S. markets are poised for a further fall today. () This "prediction," of course, is not a eureka moment. But, the markets matter. After the Federal Reserve implementedtwo rounds of quantitative easing, the stock and bond markets rose, and individual investors who suffered greatly when the markets tanked in 2008 and 2009 were lured back in. With the U.S. equity markets giving back their gains, seniors and baby boomers are watching their net worth shrink. This will be bad for consumer confidence and for the economy if seniors and baby boomers slow their spending even more. Is it time for the Fed to consider making it more attractive for every day Americans to save and pay down debt rather than to bet on the equity markets?

No. 4. What's Taking So Long? Conventional wisdom says that growth coming out of a recession should be robust. This, however, isn't your typical recession . Economics professor Kenneth Rogoff explains this well. The U.S. and Europe have debt problems—major debt problems. In his words: "Europe's plan was to have growth fix the problem. America's plan was to have growth fix the problem. And that's not going to work." There's only one way to fix a debt problem and that is to reduce debt. As Professor Rogoff says, to fix the problem, there needs to be a transfer of wealth from creditors to debtors, which results in a restructuring of balance sheets. In other words, the U.S. and Europe need to reduce their obligations to manageable levels so they can live within their means. This will result in short-term pain, but if done correctly, it will lead to long-term gains. This type of process is complex and takes time. There is no free lunch. And, as I wrote previously, you can't stop a flood by adding more water.

No. 5. Is Europe Following the U.S. or Vice Versa? When the U.S. realized that the subprime crisis was just the tip of the iceberg, it "invested" funds in the big banks to save them from failing. Then, the Fed began purchasing Treasurys through quantitative easing, which lead to artificially low interest rates and the rise of the stock and high yields in the bond market.

In Europe, the ECB loaned money to Greece to save it from default (thereby increasing the amount of Greece's sovereign debt). Now, understanding that Greece and other European countries, including Italy, have a debt problem, the ECB is buying sovereign debt on the open market. Will this help over the long term? Can Europe or the U.S. grow its way out of their debt problems?

No, they can't. The only solution to a debt problem is to reduce debt.

Reducing debt is hard. The ECB is already forcing European nations to begin austerity measures, which is slowing growth and will increase the percentage of debt to gross domestic product. The U.S. is about to begin the same type of program. The next step for both the U.S. and Europe is to reduce their debt obligations. In Europe, it is sovereign debt. In the U.S., it is unfunded entitlement programs. Is Europe following the U.S.? Or, as a friend of mine asked this morning, will the U.S. end up following Europe?

Who will figure out the solution first?

We are in uncertain times. We need political will and leadership to fix our problems. Will our leaders work together to do right by our country or will Congress fiddle while the U.S. burns?

Jon Henes is a partner in the restructuring group at Kirkland & Ellis LLP, where he has led some of the most complex restructurings in the U.S. and abroad across a variety of industries, including media, chemicals, energy, manufacturing, real estate, retail, and telecommunications. Jon has also frequently appeared on CNBC's "Worldwide Exchange" as a guest expert on various financial and economic topics, federal, state, and local fiscal issues.

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