Downgrading Standard & Poors

While it's hard to argue with S&P's political analysis, its economic judgment is a head-scratcher.

Standard & Poor’s judges that the American political system is a mess and that there should be long-term concern about its public debt. It’s hard to argue with that. But would investors really be better off buying Liechtenstein’s bonds than America’s? On what basis?

S&P says the downgrade “reflects our opinion that the fiscal consolidation plan that Congress and the administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.” While that may well be, it’s more than we were doing a month ago. Indeed, while most sane analysts agreed that the showdown over the debt ceiling was irresponsible, without it there would have been no fiscal consolidation plan at all.

Yet, John Chambers, chairman of S&P’s sovereign ratings committee, admits the downgrade “was pretty much motivated by all of the debate about the raising of the debt ceiling,” saying “It involved a level of brinksmanship greater than what we had expected earlier in the year.” But that’s an evaluation of process, not outcomes. And, again, the outcome was to actually start addressing the long-term debt problem.

Additionally, S&P apparently issued its judgment based on a $2 trillion error in its baseline assumptions. Considering that this more than accounts for the medium-term impact of keeping the “Bush tax cuts” that they so disdain in place, that would seem significant. But, having their embarrassing error pointed out to them, they decided to stick with the downgrade anyway.

Further, while letting the “Bush tax cuts” expire may or may not be a good idea in the midst of an economic crisis, the fact is that they’ve been in place for going on a decade and the decision to extend their term was taken months ago. And, as Dan Drezner points out, the debt ceiling deal makes their expiration next December the default position. Why are they suddenly so disastrous?

Daniel Indiviglio wonders the same thing. He notes that, back in May, S&P gave several strong reasons why the US today is much stronger than Japan was in 2001. And he’s not buying their explanations based on the squabbling over the debt ceiling.

A bigger deal would certainly have been preferable from a fiscal soundness standpoint.

But does the agency really estimate that the deal is is so dangerously small that there’s a realistic chance that the U.S. could now default at some point in the future? In particular, does U.S. debt really look significantly riskier now than it did in, say, April?

The bond market certainly doesn’t think so. Treasury yields are near all-time lows, despite all that political nonsense. And remember, the interest the U.S. pays on its debt is far, far smaller than its tax revenues. If the Treasury prioritizes interest payments, then there’s no conceivable way the U.S. could default.

WSJ’s Damian Paletta and Matt Phillips weigh the consequences of the downgrade:

It’s possible the blow in the short run might be more psychological than practical. Rival ratings firms Moody’s Investors Service and Fitch Ratings have maintained their top-notch ratings for U.S. debt in recent days. And so far, U.S. Treasury bonds have remained a haven for investors worried about the health of the U.S. economy and the state of Europe’s debt crisis. The pre-announcement spat could further undermine the impact of the downgrade.

But the move by S&P still could serve as a psychological haymaker for an American economic recovery that can’t find much traction, and could do more damage to investors’ increasing lack of faith in a political system that is struggling to reach consensus even on everyday policy matters. It could lead to the prompt debt downgrades of numerous companies and states, driving up their costs of borrowing. Policy makers are also anxious about any hidden icebergs the move could suddenly reveal.

A key concern will be whether the appetite for U.S. debt might change among foreign investors, in particular China, the world’s largest foreign holder of U.S. Treasurys. In 1945, foreigners owned just 1% of U.S. Treasurys; today they own a record high 46%, according to research done by Bank of America Merrill Lynch.

Late Friday, federal regulators said the downgrade wouldn’t affect risk-based capital requirements for U.S. banks—the cushion banks must hold to protect against losses. The Federal Reserve, Federal Deposit Insurance Corp. and other federal banking regulators said in a statement the lowering “will not change” the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government or government agencies.

Paul Krugman–no fan of the recent shenanigans of Congressional Republicans on the debt ceiling–is baffled by it all: “it’s hard to think of anyone less qualified to pass judgment on America than the rating agencies. The people who rated subprime-backed securities are now declaring that they are the judges of fiscal policy? Really?”

He continues:

The agency has suggested that the downgrade depended on the size of agreed deficit reduction over the next decade, with $4 trillion apparently the magic number. Yet US solvency depends hardly at all on what happens in the near or even medium term: an extra trillion in debt adds only a fraction of a percent of GDP to future interest costs, so a couple of trillion more or less barely signifies in the long term. What matters is the longer-term prospect, which in turn mainly depends on health care costs.

So what was S&P even talking about? Presumably they had some theory that restraint now is an indicator of the future — but there’s no good reason to believe that theory, and for sure S&P has no authority to make that kind of vague political judgment.

In short, S&P is just making stuff up — and after the mortgage debacle, they really don’t have that right.

If investors, quite reasonably in my judgment, decide after a weekend to cool off, that investing in the United States Monday is every bit as safe as it was at the closing bell on Friday, won’t they simply ignore S&P? Indeed, shouldn’t they do precisely that?


The firm might think it’s acting boldly or proactively. Instead, the market may question S&P’s reasoning skills. The rating agency is acting here on an assumption not shared by its peers at Moody’s and Fitch: that U.S. politics are so screwed up that they could render the nation unable to live up to its debt obligations. That’s despite pretty much everyone agreeing that the nation will be financially able to pay for its debt in the short-, medium-, and long-term.

If investors decide that S&P can’t be trusted to make a sound judgment on the world’s biggest and most information-forward fund, why would they trust it to make sound judgments on more volatile, opaque ventures?

FILED UNDER: *FEATURED, Economics and Business, US Politics, , , , , , , , , , , , , ,
James Joyner
About James Joyner
James Joyner is Professor and Department Head of Security Studies at Marine Corps University's Command and Staff College. He's a former Army officer and Desert Storm veteran. Views expressed here are his own. Follow James on Twitter @DrJJoyner.


  1. john personna says:

    Bill. Gross was on TV and was actually recommending international bond purchases.

    Yes, actually, it’s possible that Liechtenstein’s bonds are safer.

  2. Andyman says:

    Does this mean that the G fund will finally start paying off?

  3. john personna says:

    I should note that I’m not a fan of the ratings agencies. I became quite cynical about their purposes and their usefulness as the mortgage bond dealings were revealed. I also agree that sovereigns are traded in such an information rich environment that ratings are already secondary. And as I’ve said a few times, I don’t think they generally lead. I think they usually just slap a rating that represents Street consensus, after the fact.

    But while I don’t respect them general, I don’t think they are far wrong in this case. And, they might even be representing existing consensus. I mean, much of your post reads as “yes, we are f’d up, but it’s not for them to say …”

  4. steve says:

    I sure wouldn’t buy bonds from any EU country. Which countries have stable governments and a good economy now? Could go with some of the emerging markets, but I would think even those are at risk if Europe crumbles.


  5. James Joyner says:

    @john personna: I do think the idea of private companies licensed by government to rate the government is rather absurd. Especially when, as you say, investors have as much information on the USG’s credit worthiness as the S&P boys.

    But, like Krugman, Drezner, and Indiviglio, I simply think “investing in US bonds is therefore risky” doesn’t follow from “the US political system is aggravating.”

  6. john personna says:

    @James Joyner:

    Here’s the thing that jumps out at me – nobody complained that S&P should not rate Argentina in the 80’s, or Japan in the 90’s, or Greece three weeks ago. There is this contingent though who jumped up and said that a downgrade of us is different.

    Also, note that AA+ is not “risky”

  7. john personna says:

    (Basically if you believe in free speech and free markets then of course private companies can invent whatever “ratings” they want. You can start a ratings company, and more power to you.)

  8. john personna says:

    Also, in reviewing the history, I can’t see anywhere that ratings firms were “licensed” by the government.

    They started as private firms in the 1800s, grew in popularity, and were increasingly used by the government. The proper criticism would be that government should be less reliant on them, and since 2008 the government has been moving away from them.

  9. Pete says:

    A downgrade means that there will be less money available to the government for its programs. It means that debt service costs will rise. It means the Treasury will find it more difficult to place U.S. debt. It means that many holder of our debt will try to unload their positions (it won’t be easy for them). It means the Fed will likely acquire more Treasurys, effectively monetizing the debt and this monetary inflation will lead to price inflation. It means that the dollar will decline further. It means there will be pressure on the government to raise taxes further. It also means that inflation will be employed as an additional tool of fiscal policy as rising prices (actually devalued dollars) will allow the government to repay debt with cheaper dollars.

    Who cares what the ratings agencies say? The street knows better.

  10. Hey Norm says:

    I don’t think this episode works out well for S&P.

  11. Hey Norm says:

    I don’t think it works out great for the Tea Drinkers either.

  12. john personna says:

    Here is an interesting take:

    One other ratings agency, Dagong which is based out of China, has released a list of sovereign credit ratings. These are radically different than the ratings given by the big three, and it is much cause for debate. Dagong has also accused Western credit agencies with no longer maintaining their objectivity when dealing with sovereign ratings, and thinks that this bias translated to slowness in downgrading some countries in the global financial crisis. It can be read about here.

    That relates a bit to my question above, about why it was OK to downgrade Argentina, but not us.

  13. James Joyner says:

    @john personna: Too lazy to look up right now but wasn’t Argentina actually in IMF receivership and forcing creditors to forgive large swaths of debt? That is, actually in default? That’s a different situation, no?

  14. PJ says:

    Elections have consequences.

  15. JohnMcC says:

    If you, Mr Joyner, had billions to invest you would no doubt commission the best research you knew how to obtain before making those investments. “Wealth Management” specialists don’t simply do what rating agencies tell them to do—rather like one’s teen-aged children. In the last few weeks a tsunami of wealth has left The Market (peace be unto it’s holy name) and this has driven down the price of borrowing by the U.S. Treasury so low that the 13 week bond (as of closing Friday) cost the U.S. one percent of one percent. That is 0.01.

    The cost of the S&P downgrade will be born by borrowing whose credit ratings are ‘derived’ from U.S. Treasuries — municipals and hospitals are two that I’ve seen used as examples.

    So if you live at the end of a dirt road in Wyoming and never get sick, no problem!

  16. john personna says:

    @James Joyner:

    Argentina has had a bumpy history, but they have also fallen much further than “AA+”. Remember, not all downgrades are equal. Here’s a bit from 2008, not even the worst period in Argentinian history:

    BUENOS AIRES — Standard & Poor’s cut Argentina’s sovereign credit rating for the second time in less than three months Friday, sending it deeper into junk bond territory on worries of greater investor risk.

    Citing heightened concerns about deteriorating economic and political environment and fiscal pressures, S&P cut the bonds to “B”, six notches into junk bond territory.

  17. john personna says:


    On the other hand, the ZIRP has really been on the backs of US savers, including retirees.

    I get that the US “needs” low interest rates to make its messed up budget work, but let’s remember what that is doing to us little people.

  18. john personna says:

    BTW, Justin Fox’s book, The Myth of the Rational Market, has a lot of good history on S&P, as well as evolution of the US markets in general.

  19. Ron Beasley says:

    This from Digby’s blog sums it up pretty well:

    S&P’s credibility to make any sort of statements about anything at all is highly suspect. By all rights their failure to properly evaluate Lehman and AIG alone would mean that if the free market were doing its job, all the ratings agencies would have gone out of business or been disbanded a long time ago. It is remarkable that anyone on the left, right or center pays any attention to anything they have to say, much less that an entire nation quakes in fear of their oracular pronouncements. The Wall St. emperor was exposed as a naked fraud years ago, yet everyone still pretends that he’s clad in the finest raiments of wisdom.

  20. Additionally, S&P apparently issued its judgment based on a $2 trillion error in its baseline assumptions.

    I’m wondering if this isn’t just the administration spin. As I heard it explained on TV, the $2 trillion error was the result of differences in the way the calculating the projected GDP between S&P and the Treasury.

    Given that GDP projections are necessarily somewhat subjective, combined with the fact the Treasury generally uses ridiculously rosy predictions of future growth, is this actually an error or just a legitimate alternate choice of economic models?

    It wouldn’t be the first time Obama has characterized a legitimate difference of opinion as disingenuousness. The “all reasonable experts agree that…” well-poisoning has been a favored debate tactic of his for years.

  21. In short, S&P is just making stuff up — and after the mortgage debacle, they really don’t have that right.

    So what’s the argument here? Because they screwed up and overvalued things in the past, they have an obligation to overvalue us now?

  22. john personna says:

    @Ron Beasley:

    S&P’s credibility to make any sort of statements about anything at all is highly suspect.

    Technically, that is an Ad Hominem attack. It doesn’t say the argument is bad, it says the speaker is bad.

    I think there is some cognitive dissonance here. As I say in the other thread, many of us do share the S&P rationale. It’s just a question of whether the debt “resolution” matches “AAA” or “AA+”

  23. john personna says:

    @Stormy Dragon:

    The use of “right” is funny too. It is strictly speaking a 1st amendment right. And critics have a 1st amendment right to answer them, if they believe their rationale is wrong.

    Of course to do that, they have to defend the debt deal as “sufficient.”

  24. If investors, quite reasonably in my judgment, decide after a weekend to cool off, that investing in the United States Monday is every bit as safe as it was at the closing bell on Friday, won’t they simply ignore S&P? Indeed, shouldn’t they do precisely that?

    @john personna:

    I also agree that sovereigns are traded in such an information rich environment that ratings are already secondary. And as I’ve said a few times, I don’t think they generally lead.

    @James Joyner:

    I do think the idea of private companies licensed by government to rate the government is rather absurd.


    Who cares what the ratings agencies say? The street knows better.

    The problem is, that whether S&P is right or wrong, it’s not so easy to ignore their ratings, because the laws in a lot of countries give their ratings legal force. There’s a lot of big institutional investors that are required, either explicitly through legistlation or implicitly through precedent, required to hold funds in AAA securities. This goes beyond just banks to things like insurers, trusts, etc.

    These organizations are, on Monday, going to either have to dump all their treasury (and attached holdings) or pay more to have them insured against default. So even if most people thing S&P is full of it, they’re going to be compelled to act as though they aren’t, so the economic costs may end up being the same either way.

  25. Ron Beasley says:

    @john personna: I think the critique of S&P is valid but at the same time I agree with their conclusion. The reason for the downgrade was a dysfunctional political system and both the Democrats and the Republicans were called out. Everything needs to be on the table. They specifically mention the Bush/Obama tax cuts in addition to reductions in spending, entitlements and military. There is not the political will to do any of these things.

  26. john personna says:

    @Stormy Dragon:

    As I understand it, many people have been reducing their dependence on the ratings agencies since 2008, and S&P is one of many. If we use NRSRO as the US guide, there are ten.

    Beyond that, many people did not believe the AAA anyway. This could in part be a response the Chinese suggestion that the AAA was bogus. I link to “Dagong” above, and I can link to Jim Rogers here.

    I know I’m an outsider, in California yet, but I don’t think AA+ from one agency will force too much of a sell-off.

    On the other hand, as I’ve said, I do hope it will improve Washington’s response to the debt crisis.

  27. john personna says:

    Please free my comment from the queue. 3 links must be too many.

  28. Yes — it’s terrible to maintain the downgrade with fuzzy math. Does this mean S&P was trying to maintain its integrity in a foolish way or that the political shenanigans were the most influential in its decision?

  29. PS: South American country taken over by military. The “junta” promises to slash the deficit. Should the political climate have no influence on the economic climate? This principle is applied constantly to developing and new economies. Seriously, the world thinks the Tea Party antics are silly. China issued a harsh rebuke of US politics as well.

  30. michael reynolds says:

    I agree with Ron Beasely that a corrupt and discredited ratings company stumbled on a true assessment of our political system

    Here’s where it stops being a pox on both houses: only one group actually advocated for default. Only one group denied the need for a credit increase.

    It wasn’t Democrats. It wasn’t mainstream GOP. It was the Tea Party.

    S&P was rating the likelihood of default. Remove the Tea Party from the equation and there is zero likelihood of default. With the Tea Party there is something greater than zero likelihood.

    Inescapable conclusion: this downgrade is squarely the fault of the Tea Party.

  31. JohnMcC says:

    Mr Personna, thank you for the amusing acronym ZIRP — which I understand now is Zero Interest Rate Policy. You are indeed correct that there are those besides plutocrats who depend on interest payments.

    I tend to think of this issue (the larger issue – the whole deficit, balanced-budget, raise-taxes, cut-spending schtick) as a variation on the conflict that has existed here in the US since our founding: the strong-dollar vs easy-credit conflict. Goes back to the opening of the Appalachian frontier. We continuously wrangle over it. Nothing about it is permanently ‘liberal’ or ‘conservative’.

  32. john personna says:


    You are welcome. The ZIRP certainly shapes our lives, and yes it is a funny acronym.