The rating agency has some reasonable rationale for cutting the rating, but could politics really cause the nation to default?
This post was originally written based on reports of pending downgrade, but has since been updated to reflect that the downgrade is official.
After a mildly encouraging employment report, Washington's politics might manage to derail the U.S. economy anyway. Compromising to narrowly avoid a debt ceiling puncture and to cut deficits by $2 trillion might not have been enough. Rating agency Standard and Poor's has downgraded the U.S. debt rating one notch to AA+. Is this move by S&P bold and prescient or insane and misguided?
S&P made the announcement late Friday. It applies to the U.S. long-term sovereign debt rating. The agency also leaves intact the debt rating's negative outlook. Its statement says:
We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process. We also believe that the fiscal consolidation plan that Congress and the Administration agreed to this week falls short of the amount that we believe is necessary to stabilize the general government debt burden by the middle of the decade.
Our lowering of the rating was prompted by our view on the rising public debt burden and our perception of greater policymaking uncertainty, consistent with our criteria. Nevertheless, we view the U.S. federal government's other economic, external, and monetary credit attributes, which form the basis for the sovereign rating, as broadly unchanged.
In short, S&P sees the political risk as too great to sustain the U.S.'s AAA-rating.
Could Have Seen It Coming?
On some level, this shouldn't be completely shocking. The U.S. debt-to-GDP ratio is at similar level to what Japan's was at in 2001 when it was downgraded from AAA to AA+ by S&P. I prepared this chart back in May to show the relationship (red line represents downgrade point for Japan, light blue are IMF projections):
So the U.S. is clearly on the same trajectory. Perhaps a downgrade shouldn't surprise anyone?
And Yet, S&P Should Be Surprised Itself
But I asked S&P about the U.S. back in May, comparing it to 2001 Japan. One of their analysts provided numerous reasons for why the U.S. debt today shouldn't be judged as harshly as Japan's debt was then. They included:
- The U.S. has better fiscal indicators, both on the stocks and on the flows.
- The dollar remains the key international currency, while the yen is a distant third.
- U.S. prices are more stable, while Japan flirts with deflation.
- The U.S. growth prospects are better.
- Japan has particularly troubling demographics, as its population is aging and skews towards the elderly.
Nothing on this list has changed since May, but S&P has become more gravely concerned with U.S. politics. Indeed, Congress engaged in an extremely dangerous and stupid game of chicken. But ultimately, they acted in the nick of time. Whenever you've got gridlock in Congress, making big changes can be difficult. But eventually Congress groans and does what it has to do, with a result that usually makes neither side very happy. For the rating agency, this status quo must not be enough.