Defending S&P’s downgrade of the US’s credit rating

Lots of ink and many bits are currently being spilled analyzing S&P’s downgrade of the credit ratings of the United States to AA+ from AAA late Friday. Most of the talking heads in America continue to pretend to not to understand the dynamic of this action, and S&P, which hasn’t covered itself in glory over the past several years, admittedly, is taking a lot of flak for this—even Warren Buffett disagrees, and of course, Buffett is never wrong (except for those times when he is). Paul Krugman, with whom I normally agree, takes a number of pot shots, but I think misses the larger picture. Eschaton has an elegant little summary that a number of people, including Krugman, think summarizes what our reaction should be (and Eschaton, aka Duncan Black, is also an economist).

Most of the liberal commentary (and some of the commentary from the right as well) has basically taken the line that S&P has no standing, really, after its screw-ups the past several years, to opine on anything any more, particularly not the creditworthiness of a sovereign nation. S&P didn’t help its case by including a fundamental (and embarrassing) error of arithmetic in its initial press release, which the US Treasury jumped on (and which S&P duly corrected). But saying that S&P no longer has any standing to make these kinds of judgments misses the point of what rating agencies try to do, and generally do reasonably well, and why markets pay attention in the first place. If you back out the CDO debacle, S&P’s credibility is what it has always been—pretty good, as is also the case with Moody’ and Fitch. Those of us who operate in actual markets, as opposed to the academy or the blogosphere or the punditocracy, understand this. For the record, the National Journal has some of the best discussion of the repercussions of this move that I have seen.

And it’s important to note what S&P actually said, as opposed to assuming one knows what they said. (Here’s the entire S&P commentary.) It’s pretty clear that they think the situation with reference to the creditworthiness of the United States has changed, and they think it’s political. As I noted in my last post on this issue, agencies have to be very careful how they word justifications for rating actions. In particular, S&P noted two important points. The first is the following:

The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed. The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy. Despite this year’s wide-ranging debate, in our view, the differences between political parties have proven to be extraordinarily difficult to bridge, and, as we see it, the resulting agreement fell well short of the comprehensive fiscal consolidation program that some proponents had envisaged until quite recently.

OK, it’s pretty clear what they’re getting at here—the Republican-induced gridlock for the sake of political gamesmanship. Everyone I talk to in London, by the way, is equally horrified. What are these people thinking? Don’t they understand what they’re doing? My response to those questions was generally, sticking it to Obama, and no, and even if they did, they wouldn’t care. I can’t imagine that the rating agencies weren’t equally horrified. To reinforce the point, S&P later says this:

Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.

This is about as straightforward as I’ve ever seen a rating agency get in a dicey political area. One gets the sense that most observers would prefer that S&P leave politics out of it. But that’s just not possible, especially after the horror show of he past six months.

Look, anyone who has take a course in basic finance understands the concept of the risk-free interest rate—it’s the basis for everything else that occurs in finance. For decades, the functional real world embodiment of the risk-free rate has been that attached to US treasuries, because that’s what Treasuries were supposed to be—risk-free. What S&P is saying is that because of the willingness of Republicans to hold the creditworthiness of the United States as a hostage to political arm wrestling, and their intransigence on raising revenues (particularly with reference to the expiration of the Bust tax cuts), it’s not clear that investing in the securities of the United States should continue to be regarded as “risk-free.” If Republicans were prepared to blow up the credit profile of the United States once, they might be again, and next time they might get away with it.

Triple A ratings are supposed to embody as close to risk-free as you can get. That’s just not true for the US any more, sadly. If you have legitimate cause for concern about the US government paying its bills, not just its Treasury obligations, then you’ve left “risk-free” territory behind. The S&P action is simply the most recent reminder that the Republican insanity of the past eleven years that has brought us a $4 trillion dollar war, the Bust tax cuts that will never, ever go away, apparently, and other collective manifestations of political madness do indeed have costs out in the real world. Politics and the world of finance are inextricably intertwined, no matter what they teach in finance courses, and it’s pointless to pretend otherwise.

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