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?”
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?