The world's biggest bond investor believes markets will open to a changed reality

The Globe and Mail

A man stands under a screen showing the activity of the FTSE index at Canary Wharf financial district in London Aug. 5, 2011. The Euro Stoxx 50 index of blue-chip companies was down 1.54 per cent Friday and 11.06 per cent for the week. (Luke MacGregor/Reuters/Luke MacGregor/Reuters)

At times like these, it seems like a good idea to check in with the guy who heads up the world's largest bond fund. Mohamed El-Erian, chief executive of Pacific Investment Management Co., or PIMCO, believes that markets will open on Monday to a changed reality:

“Not so long ago, it was deemed unthinkable that America could lose its AAA,” he said in an article published in the Financial Times and reprinted on the PIMCO website. “Indeed, 'risk free' and 'U.S. Treasuries' were interchangeable terms — so much so that the global financial system was constructed, and has operated on the assumption that America’s AAA was a constant at the core, and not a variable.”

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While some observers have been throwing venom at Standard & Poor's for its downgrade of the United States on Friday evening, arguing that it doesn't have any credibility following the fiasco in 2008, that it got some key facts wrong in its rationale for the downgrade and that it is mostly a comment on U.S. political ineffectiveness, Mr. El-Erian argues that the global system is going to have to adjust nonetheless. That means there will be operational consequences to deal with, from re-coding risk to evaluating collateral.

The move is going to affect people at a more fundamental level as well, with U.S. borrowers likely paying higher credit costs than what they would have been paying without the downgrade. Expect headwinds on employment and investment too, which isn't good news when the U.S. unemployment rate is already at 9.1 per cent.

He also thinks that S&P probably won't stop with the United States, but could have other triple-A rated countries in its sights, including France. Should that downgrade occur, the solution to the European debt crisis could get significantly more complicated.

And then there is the impact on the global economy: “With America occupying the core of the world’s financial system, Friday’s downgrade will erode over time the standing of the global public goods it supplies - from the dollar as the world’s reserve currency to its financial markets as the best place for other countries to outsource their hard-earned savings. This will weaken the effectiveness of the U.S. as the global anchor, accelerating the unsteady migration to a multi polar system while increasing the risk of economic fragmentation.”

The good news, if you can call it that, is that these things won't play out immediately on Monday morning, but will take time to unfold. That's because the U.S. remains for the time being at the core of the global financial system.

And here's a silver lining: Mr. El-Erian believes that the downgrade could serve as a wake-up call for U.S. policy-makers. “For the sake of their country and the wider global economy, both parties should resist the urge to begin bickering. Instead they should seize this potential 'Sputnik Moment' — a visible shock to the national psyche that can unify Americans around a common vision and a renewed sense of purpose — that of halting gradual secular decline by putting the country back on the path of high growth, job creation and financial soundness.”