Defending S&P's Negative Outlook on U.S. Debt

Just when the constant criticism for missing the housing bubble had finally begun to subside, political and economic pundits were given another reason to bash rating agency Standard and Poor's yesterday. It revised its outlook for U.S. sovereign debt from stable to negative. The market hiccuped when the announcement was made, as the Dow Jones Industrial Average plummeted more than 200 points. Was the action a silly or misguided move by S&P, and does it ultimately matter?

A few of my colleagues including James Fallows and Clive Crook viewed the action with some cynicism. They aren't alone. Some economists have also pushed aside S&P's new assessment as meaningless. As much as it pains me to do so, I must, again, defend a rating agency. Let's go through some of the criticisms.

S&P Doesn't Know Anything I Don't Know

Does this criticism mean to imply that the rating agencies should stop rating sovereign debt altogether -- or just U.S. debt? After all, political and economic experts in Argentina could say the same thing about their nation's debt. This fact is irrelevant. Just like you or I could form an opinion on the U.S.'s fiscal health, so can S&P. Its decision to change its U.S. debt outlook to negative expresses its opinion.

Moreover, S&P certainly does know more about the U.S. government's financial situation than some investors. It has analysts that have run lots of scenarios imagining various outcomes depending on how the political winds blow. That's why investors care about rating agency opinions: S&P has experts who might not get it right all the time but often perform deeper analysis than the investors do.

It's Just S&P's Opinion, So Who Cares?

Calling S&P's rating action an opinion isn't a criticism: it's a truism. By definition, the firm evaluates financial data, forms an opinion, and releases its thoughts. This is why it claims First Amendment protection. It says it cannot be held liable for its opinion being wrong.

So if it's just an opinion -- why should you care? Perhaps you should not. If you have done your own analysis and formed your own opinion, then feel free to ignore S&P's. The rating agency isn't forcing you to believe that U.S. debt is more or less risky than you thought.

But in fact, the market obviously cares quite a lot about S&P's opinion, in part for the reason described above. Investors don't always do as deep analysis as the rating agencies. Even if you do perform your own analysis, it's always nice to have an independent voice to confirm or challenge what you believe. Finally, it's also useful to have some means of comparison for the credit quality of the sovereign debt of different nations. Ratings allow you to compare the debt of the U.S. to that of other nations very quickly.

There Was No New Information

This is actually a pretty common criticism of the rating agencies in general. They sometimes take action on a bond rating when nothing appears to have changed. In this case, however, this criticism isn't really valid.

In its rating action note, S&P explains why it took the action. It saw the Obama administration's 2012 budget proposal (released last week) and compared it with that from Republicans (released the week prior). It took the parties' poor track record for quick and easy compromise into consideration and worried that they were so far apart that the budget poses a risk to U.S. debt. Feel free to disagree -- that's your right, just like S&P has the right to express its concern.

The U.S. Cannot Default on Its Debt Since It Prints Its Currency

This is a strange criticism, coming from University of Texas economist James K. Galbraith, via Dave Lindorff through Fallows:

As Galbraith explains it, "US debt consists of bonds issued in US dollars, which I assume the S&P analysts know. How can the US possibly default on its own currency? The obligation is in nominal dollars, which is to say when the bond retires, the US issues a check in dollars to cover it."

Since the US prints its own currency (or actually just issues electronic payments to create new money) whenever it needs it, as Galbraith puts it, "As long as there is diesel fuel to power up the back-up generators that run the government's computers, they will have the money to back their own bonds."

Then, I take it Galbraith thinks most sovereign debt ratings are completely meaningless? Obviously, many nations print their own currency but that doesn't ensure their debt is rated AAA. For example, Argentina's debt is rated "B" by S&P, which is below investment grade. It prints its own currency too, the Argentine peso. Should it actually be rated AAA as well?

In fact, S&P is quite clear in its rating criteria that there's more to its sovereign debt ratings than just the ability to physically pay your debt by printing more currency:

For sovereign governments, the key determinants of credit quality are political and economic risk. Economic risk addresses a government's ability to repay obligations on time. Political risk addresses the sovereign's willingness to repay, a qualitative factor that distinguishes sovereigns from most other issuers. Political risk encompasses the stability and legitimacy of political institutions.

Obviously, S&P here is likely very concerned about U.S. political risk. And with a looming debt ceiling battle, it's easy to understand why.

Moreover, printing more money to pay debt will cause very high inflation, which could actually result in the debt's real return turning negative. I don't know about you, but if I were an investor, I would not consider debt risk-free if its real return is negative. That's means I'm losing some of my principal investment, if you adjust for inflation.

Journalists Overreacted to the News

Fallows also complains that journalists cared far too much about this news. He may be right, but I'm less convinced. Although I can plead "not guilty" here, since I did not cover this news yesterday, I would not criticize those who did for two reasons. The first is practical: it was otherwise a very slow day in business news. The second is principle: the news actually does matter, a lot.

In fact, S&P's rating action caused the market to plummet more than 200 points. That is news, pure and simple. When something moves markets, journalists wouldn't be doing their job if they ignored it.

And there's more to this news than the market reaction: it could indicate that S&P is mulling a downgrade of U.S. debt. A downgrade would shake the global market for at least one reason, even beyond the impact to global investors' qualitative confidence in U.S. debt -- credit ratings help to shape some investors' portfolio requirements. For example, perhaps some funds cannot hold more than 20% of their portfolio as bonds rated lower than AAA by S&P and Moody's. Yesterday's action makes real the possibility that U.S. debt will be downgraded, which would be a very, very big deal if dozens of big funds were suddenly forced to dump their Treasuries due to their internal criteria.

For all these reasons, S&P probably shouldn't be judged too harshly for its recent action. Obviously, everyone is within their right to disagree with its debt assessment. But S&P is also entitled to its opinion. It likely took the action because it wants to be out in front of the news in case the debt ceiling fight gets uglier than anyone imagined and a downgrade is necessary. If the debt ceiling issue gets quickly and cleanly resolved, and Congress agrees on a 2012 budget compromise easily, then the rating agency should probably revise its outlook back to stable. If you know anything about current U.S. politics, however, it's easy to see why S&P expresses concern about these coming battles.