One Year Later, The Debt Downgrade Doesn’t Seem To Have Mattered Very Much

One year ago, the U.S. lost it's AAA credit rating with S&P. There doesn't appear to have been any real impact from that decision.

One year ago yesterday, as the United States was coming out a two-month long standoff between the White House and the Republican-controlled House over a deal to raise the debt ceiling, Standard & Poor’s downgraded America’s credit from the long-standing AAA to AA+ largely, it said, because of lack of evidence that Washington would be able to solve the nation’s long-term fiscal problems. The downgrade was a political earthquake and was at the top of the newscasts for days afterward, however neither Moody’s nor Fitch, the other two of the three major credit rating agencies copied S&P’s action, although both did place the U.S. on a negative credit outlook for many of the same reasons cited by S&P in its downgrade decision. In the year that has passed, the downgrade has been something of a political weapon that many Republicans have tried to use against the President, but it doesn’t seem to have had much of a political impact. As Mike Konczal noted yesterday, it also doesn’t seem to have had much of a financial impact either:

The United States losing its AAA rating was a political shock. The verdict was quick from the center and the right – this would be incredibly harmful to the United States’ ability to deal with its national debt. When S&P first brought up the possibility of the downgrade in July, the centrist think tank Third Way highlighted that “S&P estimates that a downgrade would increase the interest rates on U.S. treasuries by 50-basis points,” and urged “Congress and the Administration [to] come together and pass a ‘grand bargain’ that will put us on a sustainable path and avoid a credit downgrade.”

After the downgrade Mitt Romney noted that “America’s creditworthiness just became the latest casualty in President Obama’s failed record of leadership on the economy. Standard & Poor’s rating downgrade is a deeply troubling indicator of our country’s decline under President Obama.”

Those are two empirical predictions. Did the downgrade increase interest rates on U.S. Treasuries 50-basis points? Would you go further and describe our creditworthiness itself as a casualty?

To answer that question Konczal takes a look at the chart for the ten-year Treasury bond for the past year:

Konczal concludes:

They are down a little over 1 full percentage point, from 2.58 percent to 1.51 percent. If you want to consider the baseline the 3 percent interest rates from right before the downgrade, or the 2 percent interest rates that happened afterwards, then rates are down either 1.5 or 0.5 percentage points. That’s a major decline in the borrowing cost of the United States. One can’t find the increase in rates in this market. Counterfactuals are difficult – perhaps S&P is correct, and 10-year Treasuries would be closer to 1 percent had there been no downgrade.

But that seems unlikely. Here’s a previous link discussing ratings agencies’ internal research finding that they consistently overstate the default risk of government debt. The ratings agencies can add value in thin markets with little history, or as a means of a coordinating research and action among market participants. But the United States’ debt market is one of the most liquid, traded, researched and transparent markets in the world, and it seemed doubtful the ratings agencies were going to add much information with their downgrade. A year later the downgrade appeared to have been irrelevant to United States’ borrowing costs.

There are several caveats worth pointing out here, I think.

For one thing, as I discussed in the wake of the downgrade, the fact that neither Moody’s nor Fitch followed S&P in downgrading America’s debt likely limited the impact of the downgrade itself. A downgrade by one of three ratings agencies, which some people still contend was based on a $2 trillion calculation error by S&P’s analysts, means far less than if a majority of the major credit rating firms, or all three of them, had done the same thing. At that point, it would have been a far clearly signal to the market that there was more risk than they might have anticipated in American government debt instruments. Additionally, as Megan McArdle pointed out in a post in August of last year, a downgrade by more than one rating agency would have also triggered contractual provisions that would have required some institutional investors to dump their Treasuries, thus driving the price down and the interest rate up. So, because the downgrade was limited to one agency, it’s impact was likely far less than it would have been had this been an across-the-board downgrade.

Another important factor to keep in mind here is that, despite all of our problems, the United States still remains one of the safest places to invest on the planet and U.S. Government debt instruments among the safest investments on the planet. Indeed, outside of Swiss Bonds and perhaps the Germans, there are very few truly safe investments. Because of this, and because the Swiss and the Germans don’t circulate nearly the amount of debt instruments that we do, there’s going to be a lot of demand for U.S. Government debt, and little eagerness on the part of  investors to dump their T-Bills. This is especially true, no doubt, given the current state of things in Europe where, outside of Germany, everything seems to be once form of a mess or another. So, even if S&P’s downgrade was signalling the market the our debt was less safe than it used to be, it’s still safer than most other government debt, and when you’re seeing a “flight to quality” among investors the first place they’d go is the United States and it’s T-Bills.

The final factor to keep in mind is related to the second and it involves the status of the dollar as the world’s reserve currency. Because of this, investors and institutional investors are going to want to maintain an investment presence in T-Bills.

None of this means that the debt downgrade doesn’t matter at all, or that we don’t need to address our long-term fiscal and debt issues. To a large degree, we’ve been lucky that the factors that have offset the impact of a downgrade exist. That doesn’t mean our luck will last forever, though.

H/T: Taegan Goddard’s WonkWire

FILED UNDER: Deficit and Debt, Economics and Business, US Politics
Doug Mataconis
About Doug Mataconis
Doug holds a B.A. in Political Science from Rutgers University and J.D. from George Mason University School of Law. He joined the staff of OTB in May 2010. Before joining OTB, he wrote at Below The BeltwayThe Liberty Papers, and United Liberty Follow Doug on Twitter | Facebook

Comments

  1. Drew says:

    In a bizarre personal experiment reminiscent of The Fly (and we all know how that ended), I jumped off the top of a 100 story tower.

    Note to self: Floor 50, everything seems to be fine so far.

    Seriously, it’s called QE and flight to safety.

  2. C. Clavin says:

    The Downgrade itself? No…of course not. The US is still the safest place to keep your money. And that illustrates why all the debt crisis stuff was and is nonsense. A long term problem…yes. But the immediate problem has been DEMAND all along.

    More importantly…the cause of the downgrade…the Tea Stained Debt Ceiling debacle…had a serious affect…it set back the recovery significantly. The economy sputtered, job creation slowed, and comsumer confidence dropped during last summer. Combine that with the Tea Stained Caucus blocking Obama’s efforts to develop infrastructure projects and to transfer funds directly to state’s in order to keep them from laying off public employees…and you are talking over 1% of the UE rate and around 1% of GDP. We would be at 7 something % UE and 3 something % GDP…and the feedback loops would be reinforcing the growth.

    So after Congressional Treason…your guy stands up and says Obama’s policies are holding back the recovery.
    What a scam.

  3. Yes it is great that borrowing costs for the US government remain low. But low borrowing costs are also a kind of a curse, allowing the US to continue with the fantasy of fiscal balance without sacrifice. Though Japan and the US have key points of difference (e.g. Japan’s greater ability to borrow domestically), Americans would do well to recognize that Japan still has low borrowing costs depsite a very unfavorable debt-to-GDP ratio.

  4. Dave Schuler says:

    You kind of wonder what the cost of borrowing would be if the Fed weren’t buying about 70% of the bonds put up for sale.

  5. Ben Wolf says:

    A good recap of the conventional wisdom, all of which is wrong.

    A downgrade by the other credit ratings agencies would have had no more effect. The Federal Reserve determines yields and the bond market is well aware U.S. Treasurys are risk-free and that the government can not run out of money to pay its liabilities, as I wrote at the time of the down-grade.

    Look on page 2 of the following Treasury report:
    https://www.fms.treas.gov/fmsweb/viewDTSFiles?dir=w&fname=12072500.pdf

    Look at the Government Account Series row, under Fiscal Year to Date. As of last month the federal government has repaid $50 trillion in debt. That’s $50 trillion over a seven month period.n Some would object that this a result of investors rolling their money into new Treasurys, so it doesn’t mean much, but they’d be wrong. I’d love to hear them explain how a governnment which is supposedly starved for funds and unable to pay its bills can execute millions of such payments per year with no hiccups, not a single point at which it couldn’t pay someone pack and had to ask them to wait, or juggle the books to come up with cash. Such a thing isn’t possible.

    Answer: The government cannot run out of money because it is the issuer of the currency. Bond markets know this and so don’t pay attention to the ratings agencies.

  6. michael reynolds says:

    @Drew:

    So when you’re wrong you’ll just eventually be right. Right?

    Here’s a thought experiment for you: stopped analog clock. How often is it right?

  7. michael reynolds says:

    How many times do economics “experts” have to be wrong before we begin to suspect that economics isn’t so much science as it is politics?

    This is a pseudo-science. It’s bullsh!t on a grand scale. And we’re all mesmerized by the B.S. artists.

  8. Rob in CT says:

    We remain the tallest midget.

  9. Ben Wolf says:

    @michael reynolds: Absent from Doug’s analysis is a little place called Japan, which has repeatedly been downgraded by all the credit rating agencies, yet its yields are as low as ours and sometimes lower. Their debt/GDP ratio is 250%, about 150 percentage points past what we’re told unleashes hyperinflation and summons the antichrist. Yet Japan remains deflationary and demand for Japanese bonds is still sky-high.

  10. michael reynolds says:

    @Ben Wolf:

    You’ve become the guy I listen to most. (Granted I don’t pay that much attention to economic issues.) You called this and very few others did.

  11. al-Ameda says:

    It had one rather bracing effect – it showed everyone that House Republicans were quite willing to cause a downgrade in our bond rating rather engage in actual practical governance.

  12. Ben Wolf says:

    @Dave Schuler: The onnly reason we borrow at all is because the government issued a self-imposed constraint requiring the Treasury issue bonds in equal proportion to its deficits. The idea was this would prevent the Federal Reserve from funding Treasury operations and constrain government spending, but as you’ve pointed out this obviously hasn’t worked. While the Fed is forbidden from buying Treasurys on the primary market, it can buy them on the secondary market. So private interests buy from the initial auction then sell the Treasurys to the Fed, which uses them for things like managing interest rates/bond yields. The Treasury receives the reserves from the Fed and then credits whatever accounts Congress directs it to, using the reserves to clear payments.

  13. Ben Wolf says:

    Emphasis in the last post is some sort of bizarre accident. Not shouting at you, Dave.

  14. Additionally, as Megan McArdle pointed out in a post in August of last year, a downgrade by more than one rating agency would have also triggered contractual provisions that would have required some institutional investors to dump their Treasuries, thus driving the price down and the interest rate up.

    This is true, but it is also an example of how blogs pick “a friendly” to own a position that was actually quite widespread.

  15. steve says:

    The downgrade matters because we now face the Fiscal Cliff (hate that term). Markets and businesses know that Congress is actually crazy enough to push us to the brink of default. The Congress that voted for a budget it wrote itself and required raising the budget cap, then voted against raising that cap. How could anyone not conclude that Congress is crazy? Of note, when folks have tried to measure uncertainty, it is uncertainty about the behavior of Congress that may be affecting output.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2000734

    Steve

  16. Governments invented tax, money and debt together, at the dawn of civilization. Within certain boundaries they can play with all three. The thing that’s crucial is that they keep confidence in all three. The things that make it tricky are that the boundaries are invisible, driven by human emotion, and in constant motion.

    As Ben points out, Japan has kept good confidence the Yen with high debt, but we don’t have to look very far to find others who have not been so favored. Basically in these threads we can expect Ben to say governments can do whatever they want, and then perhaps, sotto voce, after being asked he’ll say “as long as they can maintain confidence.”

    Steve’s right that the Fiscal Cliff matters, but being the cleanest dirty shirt (insert your favorite metaphor) or whatever, we are not quite as pressed as we would be if the world had a safer harbor.

  17. Related, another meme from a year ago:

    Why Many Banks Don’t Want Your Money

  18. Tsar Nicholas says:

    Any discussion of rates on Treasury debt that doesn’t mention the Fed’s recent QE programs is missing a giant elephant in the room.

    That aside, debt ratings are not what drives bond prices and ultimately the issue won’t be what S&P (or Moody’s or Fitch) say about Treasury debt. The issue will be the nation’s debt-to-GDP ratio. When that hits a certain tipping point interest rates will rise, irrespective of what the debt rating agencies say. It’s inevitable. It also will be too late to change course.

    There’s another elephant in the room. The Fed has leveraged its balance sheet in excess of 53-1. That’s simply not sustainable. Eventually the Fed will need to unwind its positions. There are three possible scenarios: (1) a flood of supply and corresponding lack of exogenous demand for Treasury debt pushes up rates, (2) people and institutions no longer are willing to hold non interest bearing cash, cash reserves then become a hot potato, and inflation in turn rears its ugly head, leading to an increase in bond rates throughout the economy, or (3) a combination of 1+ 2. No matter what the details look like it won’t end well.

  19. @Tsar Nicholas:

    That aside, debt ratings are not what drives bond prices and ultimately the issue won’t be what S&P (or Moody’s or Fitch) say about Treasury debt. The issue will be the nation’s debt-to-GDP ratio. When that hits a certain tipping point interest rates will rise, irrespective of what the debt rating agencies say. It’s inevitable. It also will be too late to change course.

    Debt-to-GDP ratio matters, but not in isolation. We are in a global savings glut, and the money must go somewhere. The markets are up. Precious metals are up. Commodities are up.

    Perhaps those Japanese bonds are considered safe, but they’d have to issue a lot more of them to soak up global savings.

  20. Dave Schuler says:

    @Ben Wolf:

    Well, that and force of habit. We’re still operating the way we did 40 years ago in this respect.

  21. mannning says:

    @Ben Wolf:

    After spending time reading Warren Mosler on Soft Money, I get the vague sense that something is missing, most probably my understanding of the unfamiliar entities, the transaction flows, and the regulating mechanisms going round and round. Mosler’s words may be quite accurate, but they do not convey to me what a fully annotated flow chart would in describing Fiat Money actions. Question is, does such a flow chart exist, and if so, where can I get one?

    I sense that the understanding of Fiat Money is absolutely key to our current and future economic posture, but it smacks of a shell game, money for nothing schemes, or anti-gravity machines, but I am sure it isn’t. Perhaps someone has written a book on the subject and illustrated it with the chart or charts I need for my own comprehension. I hate the alternative of digging out the information, say, from Mosler, and creating my own flow chart, because I could go wildly wrong. Please help!

  22. @mannning:

    For what it’s worth, in “Debt, the first 5000” David Graeber claims that even when money was “hard” gold or silver coins bought more (traded for more) within the kingdom than their equivalent weight in metal. Even then confidence was worth a premium.

  23. (I know of no such chart, but I’m not sure it would help much. Money, debt, and confidence are tied together in fuzzy ways. Historical parallels may provide a rough guide, but never an equation to map the border between good and bad.)

  24. rudderpedals says:

    I totally rely on S&P for trustworthy and accurate credit ratings. Doesn’t everyone?

    Corporate governance has changed in mostly bad ways in the last 25 years. Executive self dealing used to be technically at least presumed as a breach of loyalty to the shareholders. We’re not as much business friendly as we are entrenched management friendly.

  25. Jeremy R says:

    @al-Ameda:

    It had one rather bracing effect – it showed everyone that House Republicans were quite willing to cause a downgrade in our bond rating rather engage in actual practical governance.

    Yeah, you’d think congressional leaders talking default like madmen might just shake investor confidence:

    http://www.washingtonpost.com/politics/in-debt-deal-the-triumph-of-the-old-washington/2011/08/02/gIQARSFfqI_story_1.html

    Senate Minority Leader Mitch McConnell:

    “I think some of our members may have thought the default issue was a hostage you might take a chance at shooting. Most of us didn’t think that. What we did learn is this — it’s a hostage that’s worth ransoming. And it focuses the Congress on something that must be done.”

  26. Ben Wolf says:

    @john personna: Monetarily sovereign governments are free to spend in any quantity, but that doesn’t remove the necessity of spending wisely.

    @Tsar Nicholas

    The issue will be the nation’s debt-to-GDP ratio. When that hits a certain tipping point interest rates will rise, irrespective of what the debt rating agencies say. It’s inevitable. It also will be too late to change course.

    What tipping point? We’ve been told ad nauseam that a debt/GDP ratio of 100% is the tipping point. The U.S. already passed this. Japan passed it 150 percentage points ago and is experiencing deflation, the exact opposite of what you claim should be happening.

    There’s another elephant in the room. The Fed has leveraged its balance sheet in excess of 53-1. That’s simply not sustainable. Eventually the Fed will need to unwind its positions.

    The Fed is not revenue constrained. It can never run out of money because it simply credits accounts with whatever quantity is needed. Our government is not like a business or household which only has access to a limited supply of money. The idea of leverage doesn’t even apply to a currency issuer.

    There are three possible scenarios: (1) a flood of supply and corresponding lack of exogenous demand for Treasury debt pushes up rates, (2) people and institutions no longer are willing to hold non interest bearing cash, cash reserves then become a hot potato, and inflation in turn rears its ugly head, leading to an increase in bond rates throughout the economy, or (3) a combination of 1+ 2. No matter what the details look like it won’t end well.

    The Fed is the bond market. It has control of supply and demand. Arguing that there could be a sudden ending of demand for Treasurys is akin to arguing the sun may blow up tomorrow. Is it possible? Yes, but the probability of such an event is decidedly low. Also the suggestion that people will not hold cash is rather absurd. If you feel shaky about holding dollars I encourage you to send them all to me, then you won’t have to worry any more.

    Note that no matter how wrong Tsar and other neo-liberal spin-meisters are, they never change their tune. No acknowledgement that they’ve failed to make a single accurate prediction, but that doesn’t stop them. At some point failing to be right should make one reconsider.

  27. Ben Wolf says:

    @john personna: The closest thing I’ve seen to what you’re asking is here:

    http://bilbo.economicoutlook.net/blog/?p=332

    There’s a more detailed chart in part 2 or three I think. Fiat currency places value where it really belongs, on the real resources which are being exchanged. The money itself is nothing more than a medium for the exchange. You can think of a dollar in your possession as a claim against the total productive output of the United States, so productivity is key to the purchasing power of your dollars. When government spends it is trading its medium of exchange for the private sector’s production.

    So long as the private sector has a desire to save in that medium (dollars in our case) and gain financial wealth, this system functions effectively. If we were to suffer a collapse in productivity, end up taking on public debts in foreign currencies or experience some sort of catastrophe like a legitimacy crisis, then a wholesale rejection of the currency by the people has the potential to occur. This event is usually referred to as hyperinflation and fortunately is relatively rare.

  28. Ben Wolf says:

    n@Ben Wolf:That last post was directed at Mannning, sorry.

  29. john personna says:

    @Ben Wolf:

    This page lists a number of recent debt crises, all within living memory.

    I believe the middle line is that we have wiggle room, but certainly within real constraints.

  30. matt says:

    @michael reynolds: Glad I’m not the only one.

  31. Ben Wolf says:

    @john personna: It sounds as though you’re concerned by inflation, but inflation is a product of demand exceeding productive capacity (demand exceeding supply). What we see in our economy is a deficiency of aggregate demand, even with large deficits.

  32. john personna says:

    @Ben Wolf:

    I don’t think inflation has to be a leading event in a debt crisis.

    I think there are many ways markets can lose confidence and create macro loses.

  33. john personna says:

    I don’t think I’m overstating to say the difference between Ben and someone like Krugman is that while someone like Krugman says we are not near borrowing limits, Ben wants to push it out to there being no limits for a government with the right attitude.

  34. michael reynolds says:

    There is the overpowering reek of bullsh!t coming off the field of economics.

    I hereby formulate the Reynolds Rule: Any science which attempts to predict and fails in said predictions more than 50% of the time, is not a science.

    It may be a pseudo-science like, say, phrenology or astrology. Or it may be a pre-science, like medicine in the 16th century or psychology in any century. But it ain’t science.

    Physics predicted the Higgs-Boson and lo and behold: the Higgs-Boson. Science! Economics doesn’t know whether an unprecedented downgrading of our credit rating will send interest rates higher, lower, or have no effect. Not a science.

    Wether economics is a pseudo-science or a pre-science is yet to be determined. A good indicator would be if economists actually managed to accurately predict the next complete clusterf*ck before it happened. Another good indicator? If economists didn’t magically discover whatever their political patrons paid them to discover.

  35. mannning says:

    @Ben Wolf:

    Thanks for the reference, it certainly helps. Now it is study time; the diagrams must be amplified by the text for it to make sense in a “follow the dollar” mode to me, sort of akin to Mosler’s business card analogy.

  36. @michael reynolds:

    About half of economics is bs, the other half is interesting and useful.

  37. @this:

    The joke above is of course “which half?”

    On that, I found this bit by DeLong interesting.